Balancing opportunity and risk in UK small-cap equities

The small cap universe offers the potential to invest in tomorrow’s large companies today – by Harry Nimmo

 
In this article, we’ll look at ways to navigate the UK’s small cap market while balancing the opportunities and risks.
 
Given a backdrop of conflict in Ukraine and a lingering pandemic, investors face a lot of uncertainty at the moment.

Due to concerns about inflation, interest rate rises and tightening monetary policy in early 2022, investors in small-cap equities have been favouring “value” stocks with lower price-earnings (P/E) valuations over higher P/E “quality” companies recently.

This means there is now an opportunity to invest in quality UK small-cap companies with the potential to weather economic cycles.

These companies are available at compelling valuations. But in today’s unpredictable environment, is it possible for investors to buy tomorrow’s potential large caps without taking high risks?
 

Narrowing the search

 
The UK small-cap equity investable universe is vast. Two thirds of the world’s listed corporates are small or mid-cap companies. That’s unsurprising given that 99% of UK businesses are classified as small or medium sized.

Very few analysts cover the sector, which means experienced investors can exploit market inefficiencies.

With such a huge opportunity set, where do investors begin to look? At abrdn our starting point since the late 90s has been our stock screening matrix. Our information feeds measure the quality, growth, momentum and valuation factors that our continuous backtesting has found to be predictive of share price performance.

Our screening matrix highlights a shortlist of companies which look attractive from a quantitative perspective. Small-cap specialists carry out rigorous fundamental research on these top-scoring companies, including meeting with senior management, financial analysis, an assessment of ESG risks and opportunities, as well as a peer review process.

The result is a ‘best ideas list’ which comprises regional analysts’ highest conviction names. Each list typically contains 15-20 stocks.

Our portfolios have high weights to these strongest conviction companies, while ensuring a sufficient level of diversification as well as clear, deliberate and persistent style tilts to quality, growth and momentum.
 

Factors in focus

 
We’ve talked about the factors that we believe are important when selecting companies with the potential to enlarge their market capitalisation over the long term. But what are the key indicators of these three characteristics?
 

Growth

 
In our view, it’s important to look for companies with profitable, sustainable, growth. Small-cap businesses with supportive end markets, as well as the ability to gain market share and expand profit margins, have the greatest potential to become tomorrow’s large caps.
 

Momentum

 
We also look for signs that companies are exhibiting momentum, such as seeing upward earnings revisions and a history of consistently beating earnings forecasts.

Growth and momentum characteristics have the potential to be sustained for many years, which partly explains why small caps have outperformed large caps over the long term.²
 

Quality

 
Measures such as balance sheet strength, management pedigree and sustainable competitive advantage allow companies to successfully navigate changing economic cycles. Of course, investing in quality is also about avoiding loss-making, blue sky or highly leveraged businesses, as well as those with extremely cyclical earnings or a history of dividend cuts. Because of this, we believe, ‘quality’ companies have the potential to deliver higher returns over the long term with less volatility. This results in a more favourable risk-return profile.
 

ESG – a key indicator of quality

 
One indicator shown above is ESG (environmental, social and governance). For us, ESG factors are financially material and can affect any company’s performance both positively and negatively. A strong record on ESG issues is a key sign of company quality and can potentially help to reduce risk. Therefore, in our view, understanding ESG risks and opportunities should be an intrinsic part of any small-cap research process, alongside other financial metrics.

We also think informed and constructive engagement with company leaders can help investment managers to encourage and share positive ESG practices – potentially protecting and enhancing the value of investments for years to come.

Well-resourced investment managers have the confidence to rely on their own ESG research, investing in companies which meet their own criteria, even when not covered by external ratings agencies.
 

Risk and opportunity

 
Looking forward, the outlook for higher interest rates, potentially sustained high inflation, and a lower growth environment suggest uncertain times are ahead.

Companies selected using a quality, growth and momentum process combined with ESG analysis are potentially well-placed to weather economic downturns. Far from being dependent on externally-driven cycles, these companies are likely to expand in a predictable, sustainable way.

They are also more likely to be market leaders able to pass on inflationary costs in the form of higher prices, as well as having strong margins and robust balance sheets. Furthermore, portfolios constructed in this way are more likely to be diversified across products, markets and geographies.

We also believe that in a changing world, smaller, nimble, well managed companies that can pivot their businesses more quickly than mega caps are well placed to take advantage of evolving opportunities.
 

Final thoughts

 
Many high quality small-cap companies with the potential to expand and grow are currently available at attractive valuations. In today’s uncertain world, we believe a robust, repeatable investment process focusing on quality, growth and momentum can help investors select the large cap leaders of the future with favourable risk-return profiles.
 
More information on abrdeen Smaller Companies Income Trust >

 

 
Important information
 
Risk factors you should consider prior to investing:

• The value of investments and the income from them can go down as well as up and you may get back less than the amount invested.
• Past performance is not a guide to future results.
• Investment trusts are specialised investments and may not be appropriate for all investors.
• There is no guarantee that the market price of a Trust’s shares will fully reflect its underlying Net Asset Value.
• As with all stock exchange investments the value of the Company’s shares purchased will immediately fall by the difference between the buying and selling prices, the bid-offer spread. If trading volumes fall, the bid-offer spread can widen.
• The Company may borrow to finance further investment (gearing). The use of gearing is likely to lead to volatility in the Net Asset Value (NAV) meaning that any movement in the value of the company’s assets will result in a magnified movement in the NAV.
• The Alternative Investment Market (AIM) is a flexible, international market that offers small and growing companies the benefits of trading on a world-class public market within a regulatory environment designed specifically for them. AIM is owned and operated by the London Stock Exchange. Companies that trade on AIM may be harder to buy and sell than larger companies and their share prices may move up and down very sharply because they have lower trading volumes and also because of the nature of the companies themselves. In times of economic difficulty, companies listed on AIM could fail altogether and you could lose all your money.
• Certain Companies treat the generation of income as a higher priority than capital growth; such Companies may deduct part or all of their management charge from capital. This will increase the amount of income available but at the expense of capital growth.
• Shares of smaller companies may be more difficult to buy and sell than those of larger companies. This means that the Investment Manager may not be able to buy and sell at the best time or may suffer losses. This could reduce your returns.
• Companies selected for illustrative purposes only to demonstrate the investment management style described herein and not as an investment recommendation or indication of future performance.

Other important information:
Issued by Aberdeen Asset Managers Limited which is authorised and regulated by the Financial Conduct Authority in the United Kingdom. Registered Office: 10 Queen’s Terrace, Aberdeen AB10 1XL. Registered in Scotland No. 108419.

Find out more at www.abrdnuksmallercompaniesgrowthtrust.co.uk and www.abrdnsmallercompaniesincome.co.uk. You can also register for updates or follow us on Twitter and LinkedIn.