The case for UK small caps might look strong, but there are still reasons to be cautious.
Last week a worldwide selloff put panic into equity markets, with US and Japanese stocks at the centre of the losses. UK small caps fared much better, however, as evidenced by the Morningstar UK Small Cap index, which lost only 0.9% between Monday and Friday.
For fund managers already keen on UK small caps, this will be no surprise. For Dan Green, co-portfolio manager of the Morningstar Bronze-Medal Rated FTF Martin Currie UK Smaller Companies fund, UK small caps proved resilient because of their historically-low valuations.
Over the past three years, his £168.26 million fund has returned -24.10%, underperforming its benchmark Numis Smaller Companies ex-Investment Trusts Index, which returned -1.02%. Year-to-date, however, it has returned 11.23%, beating the benchmark by 1%.
"They have not got as far to fall because of the valuations in comparison to historical levels, but also compared to international markets," he says.
"Small caps, for instance, are still 25% below their long-term average in terms of valuation."
International investors are also looking to the UK as a safe haven because of a perceived certainty brought in by Labour's landslide General Election victory of 412 seats, he argues.
"When you compare us to other European countries like France, the UK probably looks like a bit of a haven for stability since we have got a large majority and a government with a clear mandate for the next five years," he says.
He also traces the seeds of a strengthening in UK small cap performance to last October, when US Federal Reserve chair Jerome Powell signalled the central bank would cut rates.
"Small caps outperform when interest rates peak, plateau or start to decline. Interest rates are obviously going one way and that is good for UK small caps," he says.
Though the UK Office for National Statistics this week announced a higher inflation reading for the month of July, the Bank of England is still broadly expected to continue its rate cutting trajectory, after it cut rates by 25 basis points to 5% on August 1. The cut was its first since 2020, and the first sign of a losening of monetary policy.
Small Cap Sentiment: in Step With Economic Reality?
That doesn't mean small caps are an instant buy.
Michael Born, investment research analyst at Morningstar, remains only "moderately bullish" on UK small caps because of the uncertainty surrounding the UK economy.
"Small caps are generally much more economically sensitive, and if we do see the UK or the global economy head for a recession quicker than imagined we will see a lot of pain," he says.
"In addition, flows remain challenging for the UK overall, and [UK small caps are] still an out-of-favour area even if investors are becoming more positive on UK stocks."
UK equity funds have suffered persistent monthly outflows since early 2020. In 2024, the sector's aggregate assets under management fell to £200 billion from a 2017 peak of around £280 billion, Morningstar Direct data shows.
Flows for UK Small-Cap Equity have been a mixed bag, moreover.
In 2019 net quarterly outflows reached £636 million although that number has almost halved in 2024 at an outflow of £381 million, according to Morningstar data
Despite these continued challenges, William Tamworth, co-portfolio manager of the Morningstar Silver-Rated Artemis UK Smaller Companies fund, feels that a positive economic reality has outpaced pre-existing negative sentiment.
Over the past three years, his £457.58 million fund has returned 10.6%%, beating its benchmark, Numis Smaller Companies ex-Investment Trusts Index, which lost -1.02%. Year-to-date, it has returned 15.90%, beating the benchmark by 5.67%.
"If you look at some of the recent data, inflation is now back at target, consumer confidence is rising, real incomes are rising again, unemployment is low," he says.
"And yet despite those things, we as a country and our media, we like to talk ourselves down. The new government can reset the relationship with Europe, which is a big barrier to some overseas investors looking at the UK and perhaps just as importantly to reset the narrative or the sentiment around that relationship."
Opportunities in Housebuilding Stocks
For Born, the potential winners are house builders and renewables, industries which have been bolstered since Keir Starmer's election victory. And Green agrees.
He backs MJ Gleeson (GLE), the low-cost house builder, which has been a strong performer in his fund, with its share price returning 28.63% in 2024 so far.
"Expectations of a Labour government and its proposals to unblock planning and increase the number of houses built each year has been positive for the sector," he says.
The companies Green is most bullish on, however, are those within the housing supply chain. Indeed, he holds both British ventilation manufacturer Volution (FAN) and roofing supplier Marshalls (MSLH).
"Volution can lower carbon emissions for households, and [it can] improve social housing in terms of the ventilation, which should [improve] under a Labour government," he says.
"Marshalls has got a very strong offering in solar panels. Ed Miliband wants to put a solar panel on every roof of a new build in the UK, and if you look to Scotland, new build houses do have solar panels to meet new regulations."
Opportunities in Consumer Discretionary Stocks
Tamworth is also bullish on small caps, but it's consumer discretionary stocks he most values, in the expectation businesses will benefit from falling inflation and rising consumer confidence.
"We own Moonpig, (MOON), the market leader in online greeting cards," he explains.
"We own Dunelm (DNLM). We also own DFS (DFS). The common theme is that we have been able to buy companies that are leaders in their niches at very attractive valuations because the focus has been on short-term concerns."
Tamworth also backs British pub chain Fuller's (FSTA) which is one of several businesses to launch a share buyback programme amid depressed valuations.
"The chief executive put it concisely," he explains.
"He said: 'I have got a choice. I can use our surplus cash to buy pubs in the open market, in which case I must pay fair value for those pubs, or I can buy back our own shares at a 50% discount to the price I will pay to buy a pub in the open market.'"
Tamworth sees share buyback schemes as another factor in UK small caps performing strongly, as boards with strong balance sheets are using surplus capital to play off what they feel are erroneous valuations. For as long as that trend continues, small cap investors also stand to benefit.
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