30 Nov 2018
UK smaller companies have an excellent long-term track record. They have outperformed their large-cap counterparts, numerous international rivals and non-equity investments over the past decade:
Figure 1: 10 year fund performance by IA sector (% growth)
Past performance is not a guide to future returns.
Source: Investment Association/Morningstar. Data as at 31 August 2018.
Since the EU Referendum fears surrounding Brexit and its implementation have seen UK equities de-rate. Global investors have withdrawn from our domestic market, fearing the impact of protracted negotiations, extended uncertainty and a ‘no-deal scenario’ on UK listed companies. Businesses with significant domestic exposure have, correspondingly, been most notably affected. Smaller companies are generally more impacted by changes in our economy, because they tend to be more domestically focused than their larger brethren, who have greater international sales. Companies that import products and materials to sell at home have been affected by sterling weakness since the referendum. The devaluation of sterling has put pressure on margins, requiring many companies to pass price rises on to their customers.
It is unsurprising therefore, that sentiment towards UK earnings has been more negative than global earnings since the UK voted to leave the EU. Figure 2 plots the price/earnings (PE) multiple of UK derived revenues within global equity indices against US derived revenues within those same indices. The chart illustrates the sharp discount placed on UK earnings since 2016, a signal that the market is skeptical that UK earnings can be maintained:
Figure 2: Valuation placed on UK and US earnings in global indices
Source: Invesco and Factset as at 1 October 2018. PE ratios have been derived from global indices (FTSE All-Share Index, S&P 500 Index, MSCI Europe ex UK Index, MSCI Emerging Markets Index, Nikkei Index).
The political uncertainty in Britain continues. With a deal negotiated between Theresa May’s Government and the European Union, we are, at the time of writing, closer than ever to securing an orderly exit from the EU. However, there is no guarantee that the agreed deal will be ratified by the UK Government. As the highly volatile situation continues to unfold it is unclear when we will receive clarity. At present the two most likely outcomes for 29 March 2019 remain leaving the EU. Deal, or no deal.
Deal or ‘soft Brexit’
The FTSE All-Share Index is currently trading at a 27% discount to international peers.1 Should the Brexit deal pass parliament it is likely that UK markets, and sterling, will immediately benefit.
UK smaller companies, which have traded under the shadow of Brexit for more than two years would likely benefit from increased investor interest, leading to potential re-ratings of their valuations on greater clarity of the outcome of Brexit. Moreover, a recovery in the value of the pound would offer a boost to companies, such as retailers, who import their products and sell their goods and services at home.
1 Source: Barclays as at 31 October 2018. Data reflects the price to book valuation of the FTSE All-Share Index versus the MSCI All Country World Index.
No deal or ‘hard Brexit’
Should the UK Government fail to pass its negotiated exit deal, it is highly likely that the initial impact of a ‘no-deal’ scenario will be a further decline in the value of the pound. As we experienced with the outcome of the EU Referendum in June 2016, there could well be a sharp and relatively indiscriminate sell-off of domestically exposed companies.
Although a no-deal scenario is likely to provide significant challenges to the UK, we believe that, as with the referendum result, the real impact is likely to be much less severe than perceived. Most of the companies we speak to and invest in have made plans to minimise the impact of leaving the EU on their operations. Company management teams, whilst clear that a ‘hard-Brexit’ would bring some additional administrative and cost burdens (for example setting up warehouses on the continent), do not envisage a scenario where a hard Brexit would severely impact their businesses. The impact of Brexit on individual companies will be dependent on their business model. Companies importing perishable goods from the continent are more likely to find their operations impacted by delays at the border than those importing non-perishables for example.
Crucially, businesses have had more than two years to plan and prepare. With significant negative sentiment already priced into the shares of UK companies, it is our view that a further fall post 29th March 2019 is likely to prove unsustainable across the market. The active, long-term and patient investor may find opportunities to purchase companies with strong fundamentals at historically depressed share prices. We believe that in time, markets will adapt and recover.
Investing beyond the fray
Brexit proffers a once in a generation challenge for UK equity investors. However, in times of extreme market uncertainty, it is our view that the interests of investors are best served by maintaining a longstanding and rigorous investment process. Our investment philosophy seeks to find companies capable of delivering growth without relying on the economic environment. Within the small-cap portfolios we manage,2 investments are made in quality companies that we believe have significant self-help potential, a scalable model, or operate within a growing niche. These characteristics, we believe, allow companies to continue to flourish, even against a challenging economic backdrop.
2 Jonathan Brown and Robin West are the named portfolio managers of the Invesco Perpetual UK Smaller Companies Investment Trust Plc and the Invesco UK Smaller Companies Equity Fund (UK).
4imprint: self-help, structural growth
One example from our portfolios is 4imprint, a UK listed business that supplies promotional materials. The company has significant international exposure, as the majority of its trading occurs in the US. Operating within a highly fragmented market, the company benefits from a large customer database, strong market position and supplier network. 4imprint has invested in advertising, which has facilitated organic growth within a growing e-commerce market, as businesses move increasingly online to purchase promotional materials.
In our opinion these are sustainable competitive advantages, which can help to support the growth of the business, against a changing market backdrop. Moreover, 4imprint is benefitting from the recovery in the US economy, at a time where many UK listed smaller companies are assumed to be dependent on the outlook for the UK.
Future: self-help, scalable model
Future, also held within the portfolios we manage, is a UK listed media business, which owns and has acquired a number of magazine publications. Following a change of management four years ago, the company has moved much of its content online, transitioning from a traditional magazine publishing business to digital media company. The company employs innovative methods of monetising its content, capitalising on the structural shift away from traditional print to online media. Techradar, a publication that provides objective electronics reviews and price comparison services, is one of the titles owned by Future. Like many web-based publications the company sells advertising space. However, Future also partners with hundreds of retailers to link its price comparison table with sites where the electronics featured can be purchased. If readers purchase the item online via the promoted retailer, then Future receives a percentage of the sale price as commission.
It is our view that Future is well placed to continue to exploit the structural move from print to online. The company has built a diverse portfolio of well-known titles and continues to grow its offering by acquiring influential new publications across a range of industries.
Brexit-related negativity has, and is likely to continue to dominate markets in the medium term. However, it is our view that focussing on companies with strong fundamentals and compelling investment cases that are less dependent on the economy to secure future growth, can position our portfolios to help weather the potential storm.
Concluding thoughts
The Brexit vote and extended negotiating period has caused great uncertainty for UK listed businesses. It seems inevitable that the negative sentiment towards UK listed companies will persist until we have greater clarity.
The value of active fund management, we would argue, rests in the ability to navigate the challenges posed by events such as these. We shall continue to search the UK small-cap universe for investment opportunities that we believe will enable us to meet our client objectives in the future. We believe that for the patient, long-term investor, developments in the UK’s relationship with the EU have the potential to provide investment opportunities.
Investment risks
The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.
The Invesco Perpetual UK Smaller Companies Investment Trust plc
As this is a smaller companies product, investors should be prepared to accept a higher degree of risk than for a product with a broader investment mandate.
The product uses derivatives for efficient portfolio management which may result in increased volatility in the NAV.
The use of borrowings may increase the volatility of the NAV and may reduce returns when asset values fall.
Invesco UK Smaller Companies Equity Fund (UK)
Smaller company funds are higher risk than funds that can invest in larger company sizes. Market conditions, such as a decrease in market liquidity, may mean that it is not easy to buy or sell securities.
The fund may use derivatives (complex instruments) in an attempt to reduce the overall risk of its investments, reduce the costs of investing and/or generate additional capital or income, although this may not be achieved. The use of such complex instruments may result in greater fluctuations of the value of the fund. The Manager, however, will ensure that the use of derivatives within the fund does not materially alter the overall risk profile of the fund.
Important information
Where individuals or the business have expressed opinions, they are based on current market conditions, they may differ from those of other investment professionals and are subject to change without notice.
This article is marketing material and is not intended as a recommendation to invest in any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication. The information provided is for illustrative purposes only, it should not be relied upon as recommendations to buy or sell securities.
For the most up to date information on our funds, please refer to the relevant fund and share class-specific Key Investor Information Documents, the Supplementary Information Document, the Annual or Interim Reports and the Prospectus, which are available using the contact details shown.
For more information on our investment trusts, please refer to the relevant Key Information Document (KID), Alternative Investment Fund Managers Directive document (AIFMD), and the latest Annual or Half-Yearly Financial Reports. This information is available using the contact details shown.