Investing in UK smaller companies seemingly requires a degree of optimism that the national economic debate rarely encourages. Although the recent swift appointment of Andy Burnham as prime minister may have eased immediate political uncertainty, rising government borrowing costs constrain his room for manoeuvre.
It is easy to understand why investors might continue to look elsewhere. However, is there more to small-cap investing – particularly at the quality-growth end of the spectrum – than simply how the UK economy is performing?
Sometimes, just as important is picking a manager that can identify individual companies able to grow their earnings in spite of a difficult backdrop, and access that growth at a sufficiently attractive price.
Specifically, specialist businesses can serve international customers, benefit from investment in particular industries, or build leading positions in markets whose growth bears little resemblance to the national average.
Companies can also improve their prospects without waiting for a broad economic recovery through strong leadership, cutting costs or growing prudently.
Value can also emerge through takeover activity. Corporates and private equity have cottoned onto the value available in the UK market and are taking full advantage. Stocks such as Rotork, JTC and Alpha Group have all had recent approaches at premiums of more than 50%.
Those offers suggest that corporate buyers can place considerably greater value on individual businesses than the stock market does. Nonetheless, an acquisition can remove a promising business from the market before its longer-term potential is realised.
Two trusts show there is a way
Among those managers who have a relevant track record of small-cap investing against a difficult UK economic backdrop are two quality-growth managers Roland Arnold of BlackRock Smaller Companies Trust (BRSC) and Charles Montanaro of Montanaro UK Smaller Companies Investment Trust (MTU).
BRSC's recent experience provides some useful examples. In its July update, Arnold highlighted Irish food company Greencore's increased profit guidance, which is being driven in part by its recent acquisition of Bakkavor, and improving orders at specialist electronics group discoverIE, which is benefiting from a number of secular growth trends including the build-out of renewable energy, the electrification of transport and the adoption of wearable medical devices.
Arnold also sees opportunities where valuations fail to reflect longer-term earnings potential, including in sectors such as construction, engineering and property.
For MTU, the question has been when will sustained business progress translate into better investment returns. There has been some progress – the trust's six-month numbers are towards the top end of the peer group league table.
Nevertheless, Montanaro reports that the portfolio's companies have delivered average annual earnings growth of 10% over the past decade; yet the portfolio's forward price-to-earnings multiple has more than halved since 2021, thus illustrating how falling valuations can overwhelm operational progress.
Valuation pressure cannot explain every disappointment though. MTU had exposure to Cerillion, a telecoms billing and customer management software business, for example. It was one of a number of UK software and data stocks that derated on the perceived threat of agentic AI.
This illustrates the need to distinguish between companies whose operational progress has simply gone unrewarded and those where the investment case itself may have deteriorated.
The investment trust structure of the likes of BlackRock Smaller Companies and Montanaro UK Smaller Companies can give managers additional scope to exploit these opportunities.
Gearing allows them to borrow to invest more in companies whose prospects they believe the market undervalues, potentially enhancing shareholder returns as earnings grow or valuations recover. Investors buying trust shares below net asset value can also benefit if the discount narrows, as has been the case with BRSC in recent weeks.
Overall, then, the case for UK smaller companies should rest on more than the hope that sentiment towards Britain improves. It requires evidence that businesses are strengthening their competitive positions, generating cash and investing productively, alongside valuations that leave room for investors to benefit.
These two trusts, and others, offer portfolios through which to test that argument. A more supportive economy would make their task easier, but investors need not wait for every national indicator to turn favourable before examining the case for UK smaller companies.
The opportunity lies in identifying where pessimism about the country has led to excessive pessimism about a stock – and retaining enough discipline to recognise when it has not.
David Batchelor is a senior analyst at QuotedData. The views expressed above should not be taken as investment advice.