In our view, at this moment, the opportunity in UK small companies (those too small to be included in the FTSE 250) is excellent for a number of reasons. 
First, historically, small companies have generated superior returns in the UK as one of the best performing asset classes according to data from the Investment Association. This is a function of their greater ability to grow (from a smaller base), being less well known and off the radar of many investors and not being as widely owned. However, over more recent years, the performance of UK small companies has been someway behind the larger end of the UK market. Perhaps unsurprising given the backdrop in the UK.
Despite the recent bounce in share prices post the general election, the FTSE Small Cap index (18.82 per cent) and the AIM All Share index (13.26 per cent) materially lagged the mid-cap FTSE 250 index (28.88 per cent) in 2019. We believe the more muted performance of genuinely small companies over recent times is for several reasons. Small companies are perceived to be higher risk and, with the well-discussed changes brought about by MiFID II, less well researched and more illiquid. Outflows in this sector have been vast (according to the Investment Association), further dampening small company valuations over recent months and years. Companies with a market capitalisation even sub-£1bn is a part of the market commanding ever less attention. This is further manifested in the small-cap discount to mid-cap. This has peaked to multi-year levels (see chart) and historically has been followed by a reversion. In our view, this provides a great opportunity for focused small-cap investors.
Source: Liberum
Second, small companies contain many attractive qualities long term investors should value. Far from being ‘high risk’, the lower end of the market is a fertile ground for quality companies. Companies with highly attractive characteristics such as strong cash flows (e.g. Alliance Pharma), repeatable revenues (e.g. Medica), limited exposure to economic cycles (e.g. XPS Pensions) and strong financial positions (e.g. Ergomed) abound. These qualities are a good basis for the delivery of strong long-term shareholder returns.
Third, history has shown that valuation anomalies rarely persist in the long term. The gap closes as companies re-rate on the public market, or, as is often the case, quality small companies get acquired. Private equity fundraising has hit record levels in recent years which is being and will continue to be put to use; ‘Private Equity races to spend $2.5trn cash pile’ was an article in the Financial Times this summer. The level of ‘dry powder’ is already two times the levels of 2006/07. Debt financing is generationally cheap with very low interest rates and is widely available to source for prospective acquirers. Furthermore, low starting valuations enhance prospective returns for financial buyers. Public to private activity has been evident in 2019 with a regular flow of deal announcements at the smaller end of the market. For example, in our portfolio, large holding IFG Group was taken private by Epiris Private Equity at a 46 per cent premium earlier this year. According to Preqin, the data provider, investors view small to mid-market buyout funds as presenting some of the best opportunities in private equity.
Whilst near-term investor focus is very much on attempting to catch those companies that will offer strong returns benefiting from the clarity provided by a recently elected Conservative majority government, UK small caps are well placed beyond this. It has become a more neglected part of the market owing to the diminution of broker and investor attention ensuing from MiFID II and the growing concerns over liquidity. It also remains mischaracterised. Whilst there will inevitably be some ‘riskier’ small companies, there are also many high-quality niche market leaders with valuable IP and attractive growth and cash flow characteristics. We believe the valuation discount applied to these high-quality smaller companies should not persist over time and if it continues, transactions will, as they have in the past, provide a good means to generate shareholder value.
We are often asked ‘how the portfolio is positioned’ or ‘how to navigate the prevailing (always uncertain) environment’. Our answer is consistent. Whilst always mindful of the economic environment and its impact on our investible universe of companies, our approach is grounded in a longstanding process. Invest in high quality covetable small companies trading at a discount to their fundamental value based on their ‘real world’ value, this being how private equity would value their cash flows. This provides a strong precedent for valuation and a good compass in all environments. We believe the prevailing environment provides real opportunity for small-cap investors.
Jeff Harris is co-manager of Strategic Equity Capital. The views expressed above are his own and should not be taken as investment advice.