Investors who want exposure to growth stocks but baulk at the high valuations on many of the household names in this area of the market simply need to look towards small-caps, according to Georgina Brittain, manager of the JPMorgan Smaller Companies Investment Trust.
IA UK Smaller Companies is the best-performing sector in the IA universe so far in 2021, with gains of 20.34 per cent. Over one year, it is up 53.49 per cent.
However, Brittain said that it is not too late to invest in this area of the market.
“Clearly, valuation is a crucial question,” she said. “We've been looking out to 2022 because a lot of 2021 forecasts are still distorted by the ongoing pandemic and lockdowns.
“When everyone talks about the UK as cheap, generally they're talking about the FTSE 100 – the FTSE 250 is back pretty much to par at 15x, a number which over the last decade or so is very much the median.
“But if you look at our index, The NSCI [Numis Smaller Companies] plus AIM, you can see that 18 months out, the P/E ratio is 13.5x and that is based on almost 20 per cent median earnings growth for this year and 18 per cent next year.
Valuations of UK stocks
Source: JP Morgan
“For almost 40 per cent growth over the two years, you're paying 13.5x. So we absolutely do not believe that this boat has sailed: the story has a lot more to go.”
Brittain added that not only is this growth potential available on a reasonable valuation, but that it may be underestimating the true picture, with a clear trend for earnings upgrades across the market.
There is also optimism among UK consumers, with confidence now at pre-pandemic levels, according to a study from market research firm GFK. More important, however, is that they have the money to act on this.
“Everyone has different numbers, but you'll be very aware that between £125bn and £160bn of excess household savings have been put away over the last year or so,” Brittain continued.
“We all know why: those of us who are busy working, but working from home – so still getting the nice salary – are basically unable to spend it and have just built up savings.
Source: JP Morgan
“And I think the only debate is what percentage of that is being spent and will be spent. And given how hard it is for any of us to leave this country and go on holiday, it's largely going to be spent in the UK.”
Another reason to be optimistic is what Brittain calls an IPO frenzy, with 32 flotations in the small-cap universe in the year to 31 May, a figure she called “astonishing”.
The manager took a selective approach to these companies, ignoring those that are too small (she tends not to invest in companies below £70m in size) or not yet profitable. This took the number down to 20, and she decided not to pursue her interest in a further three of these, for a variety of reasons. Her team then fully researched the remaining 17 companies and ended up investing in just six, which Brittain said have generated a “very pleasing and significant excess return”.
Just as new companies are coming to market in the small-cap universe through IPOs, many are being taken away through M&A activity. The trust has only benefited from this once over the past year, when Codemasters, a video game company focused on the racing genre, was bought out.
But Brittain’s co-manager Katen Patel said there have been plenty of other bids in the small-cap universe, which is unlikely to stop any time soon.
“We feel like we haven't been dealt a fair hand in the M&A space,” he said. “It's not something we target, but clearly we like [companies with] good balance sheets and good returns so we'll continue to be a beneficiary should that trend continue.
“By all accounts, from everything we hear in terms of dry powder – private equity houses for example, low funding rates clearly as well – we do expect M&A to continue.”
The final reason to be optimistic about this area of the market can be seen not in the words of the trust’s managers, but in the actions of its board.
It has a maximum gearing of 10 per cent and is now close to this level.
“There are many, many opportunities that we're looking at it,” Patel said. “And we are having to sell to buy because firstly we are very comfortable with valuations and the outlook, and then again just the opportunity set that we're finding is really leading us to be very comfortable, with gearing right up at the top of our range.”
Data from FE Analytics shows JPMorgan Smaller Companies Investment Trust has made 363.3 per cent over the past 10 years, compared with gains of 232.26 per cent from its IT UK Smaller Companies sector and 144.97 per cent from its Numis Smaller Companies plus AIM ex ITs benchmark.
Performance of trust vs sector and index over 10yrs
Source: FE Analytics
The trust is on a discount of 6.44 per cent compared with 6.92 and 11.01 per cent from its one- and three-year averages.
It has ongoing charges of 1.01 per cent.