The onus is on fund managers to make UK small-cap stocks re-rate from their current low levels, as international investors are unlikely to return to the domestic market any time soon.
This is according to Trevor Green, manager of the Aviva Inv UK Smaller Companies fund.
The FTSE has traded at a discount to other international developed markets ever since the UK voted to leave the EU in 2016.
This had led many UK fund managers to refer to their home market as ‘cheap’ and urge investors to buy in before it re-rates to a level in line with its peers.
Yet Green said there is no hurry.
“Every small-cap fund manager says, ‘I own lots of cheap stocks’,” he explained. “Well, if there are lots of cheap stocks, it’s very difficult to stand out from the crowd.
“That’s partly down to sentiment, and whether we can actually get people allocating capital to the UK. But we haven't had it since Brexit. Obviously what Liz Truss said has unnerved people and UK credit ratings have been put on watch.”
He added: “These are not good signs for small caps. The AIM is down about 35% this year and the FTSE small cap is down 20%. That's a lot for indices to fall, and it's going to be a struggle for these companies to come back from here.”
Performance of indices in 2022
Source: FE Analytics
Green admitted many of the headwinds facing the UK small-cap sector are out of investors’ control. For example, he pointed out that energy costs in the UK are materially higher than in the US, making it difficult for domestic companies to compete with their international peers.
“I don't think it's up to me or you to have been on top of the UK's energy independence,” he added. “That's what governments are there to do and should have been doing for decades.”
Yet there are a couple of areas in which Green said fund managers can help themselves.
He meets regularly with company management teams to establish where they hope to take the business in the next three to five years. Green said it is important to be patient with them and that he has no problem with early-stage companies that are suppressing potential profits today in order to invest in the business.
Yet he also said they need to admit when things aren’t working – and this is where fund managers need to help.
“There’s a lot of onus on fund managers,” he explained. “We're running into this problem where companies are getting down to £25m, £50m or £75m market caps, and investors just aren't going down there anymore.
“So these companies have really got to think along with shareholders, ‘what are we going to do to stop us being lost and left forever?’”
For example, portfolio holding Science in Sport, which manufactures nutrition products such as protein bars and gels for professional and amateur athletes, recently announced a strategic review that may result in a full or part sale of the business.
“Other companies have got to be thinking ‘how are we going to get out of here?’ and considering M&A,” Green added.
“But companies are really going to have to do it themselves with shareholders pushing them to consider their options.
“They also have to understand that if they want to raise equity instead, it is very dilutive and the small-cap end is at a really big discount. The index as a whole is hard to get really bullish about.”
On the plus side, Green said that while UK stocks are struggling to sell their shares to international buyers, they are having no such problems when it comes to selling the entire business.
He added that the falling pound hasn’t led to surge in M&A activity, but this is only because it was already close to record levels.
The manager has also been encouraged by the ease with which most portfolio holdings have managed to pass on price increases, despite initial concerns about upsetting customers.
On the whole though, he is not particularly optimistic, which is why he is taking a safety-first approach.
“The market’s actually been quite efficient in smaller companies and there have been some cheap stocks with flaky business models that have been found out,” he said.
“Although it's not a smaller company, Greggs’ business model is absolutely proven to work in a normal environment, it has seen very strong like-for-like sales and is keeping its cost guidance for the year.
“There's a business model that works and when we get back to normal times, you can feel confident in it. I'd rather pay up for that than something that finds it hard the minute consumers run into a bit of trouble.”