Domestic-facing smaller companies could be set to pleasantly surprise investors over the medium term despite Brexit fears, according to Miton’s Gervais Williams. 
The managing director, who also runs several funds for the firm including the five crown-rated CF Miton UK Multi Cap Income fund, says the ongoing hunt for yield via mega-cap ‘bond proxy’ stocks could finally be coming to an end as inflation pressures continue to build.
As such, he is seeing a wealth of attractively-priced recovery stocks further down the cap spectrum that have been overlooked by many investors due to geopolitical uncertainty.(pictured).
“The natural inclination is to be a little bit worried because we have had a very robust market recovery since 2008 and here we are five or six years later,” Williams said.
“We also have to consider that economic policies are changing more now than they have done for the last 30 years. On that basis, we don’t just have the uncertainty from Brexit or Trump but also the European election and whether there will be any policy changes going forwards.
“So from that point of view, we have to be a little anxious about the whole pattern of markets changing. In terms of absolute gains, it is shocking to still be buying – at this stage in the bull market – companies at less-than-cash balances.”
He added: “These kinds of opportunities are just amazing to be beholding at this stage in the cycle and that tends to happen.
“If the bull market is coming to an end over the next year or two, often you see some of the best returns in terms of actual rises in markets towards the end of the period as people get enthusiastic.”
While many investors were worried that the uncertainty of a ‘leave’ vote in last June’s EU referendum would negatively impact markets, the subsequent weakness in sterling had the opposite effect and caused the global-facing FTSE 100 index to rally.
As stocks further down the cap spectrum were left behind comparatively, the small- and mid-cap indices still finished the year with positive returns.
However, expectations for rising inflation, rate hikes and a boost in global growth has led to a surge in positive investor sentiment, which has therefore bolstered the stereotypically higher-risk and domestic-facing areas of the UK market.
Year-to-date, the FTSE 250 and FTSE Small Cap indices have comfortably outperformed the FTSE 100 while the AIM All-Share has more than doubled its returns.
Performance of indices in 2017
Source: FE Analytics
“These rises and this enthusiasm does mean that some of the upside when it comes could be more substantial,” Williams said.
“Some of our larger holdings have done really very well, such as Burford Capital, IG Design Group or Fulcrum Utility; the share prices have really, really risen.
“If we get anything like that elsewhere in the market, we could be very surprised by the strength of the returns available.”
Given the length of the current bull market, however, the manager remains cautious as to how long this economic cycle will continue.
“I would have [called the end of the cycle] a year or two ago. I’m probably a bit of an ‘Eeyore’, I tend to be worrying about the downside all the way up, which is funny if you look at some of the funds because they’ve made out like bandits.
“I wouldn’t say I’m a pessimist, I’m just always worrying about the downside and fortunately, despite that, some of the funds have really done very well.”
Williams’ £812m CF Miton UK Multi Cap Income fund, for instance, has outperformed its average peer in the IA UK Equity Income sector by 52.66 percentage points over five years with a total return of 121.92 per cent.
Given Williams’ air of caution and focus on valuation risk when it comes to investing, it has done so with a top-decile Sharpe ratio (which measures risk-adjusted returns), downside risk (which measures susceptibility to lose money during falling markets) and annualised volatility over the same time frame.
Performance of fund vs sector over 5yrs
Source: FE Analytics
In a bid to maintain this performance, he has recently increased his exposure to domestic-facing consumer stocks – which he has been significantly underweight in relative to the broader market – at the expense of oil and gas stocks which have rallied over the last year or so.
“We didn’t have a lot of consumer positions – we had two or three in the multi-cap income fund but in the smaller companies fund we had almost none. What happened this year is that January and February’s economic data has led us to become a little less negative on the consumer sector,” Williams explained.
“What it said to us was consumers are going to be a bit short on money but, on top of that, the banks are probably in better shape now. They’re starting to renew lending so, if anything, you’ll find that not only are banks starting to increase lending, but consumers are increasing their borrowing. That will drive the UK economy in the short term.
“It is still a little unproven, but there is early evidence that this is beginning to happen. The UK economy is continuing to grow pretty well and that’s beginning to be a positive surprise now. In fact, if I’m right, we could see the UK continuing to be one of the more robust economies in the whole of Europe, which could put the smaller companies sector – which does have some overseas earners but also has some domestic earners in it – in pole position.
“The valuations are cheap, there’s been a takeover boom but, most importantly, we think that the institutional interest in the bottom of the market could be starting to rise again and we think that will drive a period of unexpected outperformance in smaller domestic earners.”
In an article later in the week, FE Trustnet will take a look at William’s unloved small-cap stock picks that he expects to do well over the long term.