Small wonders: the hidden gems among smaller companies

In a stock market dominated by moonshots, no-one is thinking very much about UK smaller companies. It has been easier to find support for untested companies with a great story than companies with tangible earnings, established markets and a clear pathway of growth. That is both a problem, and a super-power. It means that there is a wealth of high-quality companies, overlooked by investors, ripe for reappraisal. 

At first glance, this may not appear to be an ideal moment to be investing in the UK stock market. The economy is lacklustre, the political situation wobbly, and there has been a spike in borrowing costs in response to the Iran crisis. These factors may hurt sentiment, but they do not necessarily affect the operational success of many smaller companies. In the gap between sentiment and reality lies an opportunity. 

Most importantly, it means investors don’t need to pay peak prices to gain access. The growth of AI may be exciting, but few are unaware of its potential and that is reflected in valuations. In contrast, expectations for UK smaller companies are low. By our estimates, small and mid-cap companies are on a 20% discount to their long-term average.

The nature of UK small caps

The UK small cap market is diverse, spread across a broader range of sectors than its large cap peers. It includes financials, healthcare, industrials, consumer, even technology companies. Despite their reputation, UK smaller companies are not exclusively exposed to the domestic economy. Many have international revenue streams. In a diverse market, active investors can shape the type of exposure they want. 

Equally, while they may be smaller, they are not start-ups. They are often long-standing companies, with well-established markets. That might be investment platform A J Bell, with 723,000 customers and assets under management of £9.8bn. Or Bloomsbury Publishing, home of novelist Sarah Maas, whose ‘romantasy’ books have sold more than 75 million copies worldwide, and JK Rowling, author of the Harry Potter franchise. 

Many have solid fundamentals. Across the Aberdeen UK Smaller Companies Growth Trust, the average annual earnings per share growth for portfolio holdings has been 15.5% over the past five years. The companies in the portfolio are growing their sales at an average of 13% per year. Apple’s last set of annual results showed it growing its sales at around the same level.

They even pay dividends. Investors have assumed that large cap companies are where they need to go to find dividends, but small and mid-cap dividends now compare favourably with their large cap peers. The FTSE 100 has a yield of 3.1%, while the FTSE 250 and FTSE Small Cap yield 3.7% and 3.8% respectively. Those dividends are growing – an important factor for any investor that wants to preserve the purchasing power of their income over time. The five-year annual dividend growth for the Aberdeen portfolio is 14%. 

They are also plugged into major growth trends. UK infrastructure companies, for example, are significant beneficiaries of the drive to build more homes, data centres and to reconfigure the UK’s energy network. The trust holds approximately 10% in Balfour Beatty, Galliford Try, Renew and Morgan Sindall. Again, they have been overlooked because they are seen as vulnerable to the UK’s domestic economic weakness, but we believe that’s a misreading of the structural factors underpinning their growth. 

Lower valuations

It is no secret that smaller companies have had a difficult period more recently, a legacy of the UK’s various political upheavals, volatile borrowing costs and weak domestic growth outlook. However, historically, smaller companies have generally grown faster than their large cap peers. The reasons for this “small cap premium” have been hotly debated, but it appears to be a combination of their greater agility, the lack of research, and because they are more likely to be acquired. Equally, larger companies need to find more customers to grow their business by, say, 10% than smaller ones. 

Smaller companies always tend to go through periods where they are in and out of favour and at each point, investors have found reasons why the small cap premium may no longer exist. In our view, there is no reason to think that the structural advantages of smaller companies have suddenly disappeared. Certainly, the growth, agility and dynamism of smaller companies are still firmly in evidence. 

Why active management?

Smaller companies can be riskier. They tend to be less diversified, which can leave them more vulnerable to changes in market dynamics. Overall, companies in the Deutsche Numis Small Companies Plus AIM index have seen earnings fall over the past three years. Selectivity, knowing what you’re buying, and handing capital to capable management teams is vitally important. 

There will always be smaller companies where debt is too high, or cash flow too weak. The small cap premium is not universal and there will be ‘fallen angels’ in the small cap universe. These are companies with some form of structural weakness that means they are losing relevance over time. To harness the small cap premium in full, investors need to be discerning.

We look for those companies that can weather economic storms without compromising their long-term growth potential. We invest in companies with low leverage, low earnings volatility, and stable return profiles. This is a volatile environment, with all companies buffeted by forces such as inflation, tariffs and fragile geopolitics. Quality companies are inherently better positioned to face these challenges.

The market hasn’t particularly valued these ‘quality’ characteristics in recent years, but this has left this type of company looking very cheap. Our portfolio, with average earnings per share growth of 16.2%, trades at an average price to earnings ratio of 13.8x. That’s only marginally ahead of the index, for significantly faster growth profile. We continue to be able to buy quality growth businesses at very attractive valuations.

Smaller companies have been overlooked. This has left some growth gems at historically low prices. Even if sentiment is still weak, trade and private equity buyers are supporting valuations. Also, under-rated may be the ability of UK smaller companies to act as a diversifier against the dominance of AI, bringing alternative growth themes into a portfolio.  

Companies selected for illustrative purposes only to demonstrate the investment management style described herein and not as an investment recommendation or indication of future performance

Important information

Risk factors you should consider prior to investing:

• The value of investments and the income from them can fall and investors may get back less than the amount invested.
• Past performance is not a guide to future results.

Discrete performance

Source: Workspace Datastream, total returns. The percentage growth figures above are calculated over periods on a mid to mid basis. NAV total returns are on a cum-income basis. 
Past performance is not a guide to future results