Written by Citywire

July, 2020

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UK smaller companies: who are the bulls and bears?

Small caps tend to fall more sharply in a bear market but bounce back stronger and outperform over the longer term. Citywire asked several wealth managers and advisers to reflect their current view on a scale of one (most bearish) to ten (most bullish)

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Tom Munro, director of Falkirk-based Tom Munro Financial Solutions, is the most bullish of those we interviewed. In April, he increased exposure to UK smaller companies to 10% for a balanced client.

‘Covid-19 sent a wrecking ball straight through the sector in Q1 2020,’ he said. ‘Small caps will always fall further than large caps – that is the price of greater risk – but over many years our clients have enjoyed long-term outperformance, especially in the UK,’ he said.

While the short-term impact of Covid-19 weighs heavily on many companies and a more recessionary global landscape is almost certain, Munro is confident that, for most managers in the UK smaller companies sector, their ‘defensive credentials should hold good’.

‘Careful repositioning should ensure the vast majority of businesses held within portfolios have strong enough balance sheets to withstand the worst of the looming environment throughout the remainder of this year and well into 2021,’ he said.

He favours funds with a focus on sustainability and bias towards companies benefiting from structural growth drivers.

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Canaccord Genuity Wealth Management likes carefully selected UK smaller companies, even in the current environment.

‘Although they are more dependent on earnings generated in the UK than their larger peers, and it appears the UK is not navigating the Covid-19 outbreak as well as other countries, they are also more nimble and diverse than behemoths of the FTSE 100,’ said deputy chief investment officer Richard Champion.

‘They also better reflect some of the most successful themes that lockdowns across the world have fostered – a huge increase in working from home, much greater use of internet retailing, a surge in online gaming and greater focus on environmental, social and governance factors.’

While the FTSE 250 index is down 19% in the year to 23 June, Champion points to names such as online fashion retailer Boohoo and games developer Team17 posting strong gains.

‘We play smaller companies through names such as these and funds, which in the UK tend to be positioned somewhat away from the largest companies,’ he added.

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For Louis Coke, a senior investment manager at Charles Stanley, smaller companies may lack the same external funding facilities that larger peers can call on but have ‘one vital attribute: flexibility’.

‘Smaller companies can adapt and develop their business very quickly, unlike for example a 20,000-person organisation spread across 15 countries,’ he said.

‘Smaller companies undoubtedly struggle in tough economic times. However, it is important to remember that beneath every ticker symbol is a company – living and breathing, selling products and services and run by a hopefully competent management team.’

His bullishness on the outlook for smaller companies comes with one important caveat – they are for those who are patient.

‘The current market is an opportunity to allocate capital to disciplined, active managers who know the area well,’ he said. ‘There will be many companies that come to the market over coming months in search of fresh equity capital. There could be great opportunities for those with conviction and the right skillset in picking good businesses and strong management teams.’

For Nexus Investment Managers, which runs portfolios for Hampshire-based Nexus IFA, the case for UK small and mid-cap investing is evident in statistics: they make up 93% of quoted UK companies, employ three million people and contribute more than £26 billion in tax.

‘Long-term prospects are compelling as small companies can be among the most exciting businesses around,’ said portfolio manager Lucy Kupczak.

‘Looking at profitability, it is much easier for a company to grow its profits by 20% when those profits are much smaller, while larger firms will struggle to match such growth rates. However, for every success story, there will be plenty of disasters as many will stay small or completely disappear.’

Kupczak typically allocates around 3% of a balanced portfolio to UK smaller companies – a figure that has not changed of late but that she is considering increasing as the coronavirus pandemic unfolds. ‘Smaller size means flexibility and the ability to adapt to changes more quickly,’ she said.

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In the short term, Smith & Williamson is ‘pretty neutral’ on UK smaller companies, assigned itself a rating of five out of ten.

James Burns, co-head of its managed portfolio service, said: ‘As with the whole of the UK equity market, we are waiting to see how much lasting damage the economic shutdown has caused to companies and we’re unlikely to see the full extent of this for a while. It is possible that many have fared better than expected, but we will have to wait and see.

‘There is also the thorny issue of Brexit still to be dealt with, which could further knock sentiment to the UK, already one of the most unloved global markets.’

For investors with a longer-term view however, having exposure to smaller companies with their faster growth profile ‘makes sense in a balanced portfolio’, he said. ‘We should be looking to build the position back up as and when we gain a bit more clarity on the market environment,’ he added.

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TAM’s exposure to UK smaller companies at this juncture is small but high quality.

‘With much of the recent strength in smaller company stocks coming hand in hand with the rally in value stocks we see the UK smaller companies market as needing a positive V-shaped recovery to firmly cement itself into the investment narrative before we see long-term strength being sustained here,’ said chief investment officer James Penny.

‘Given the path to economic recovery remains far from clear, there remains a prevailing risk to this UK sector in the short term, which keeps a lid on us going overweight in our asset allocation.’

For now, TAM has moderate exposure to UK smaller companies with a high-quality tilt. ‘While there’s a huge amount of value in smaller companies, there remains a large amount of solvency risk at the smaller end of the market as a result of the government shutdown. As such, active management in this sector remains paramount to us over a passive approach,’ Penny added.

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