Investment trusts: a rare opportunity in UK small and mid-sized companies

Opportunity knocks for UK small and mid-sized companies – find out why

UK equities have been more resilient than many other world markets in 2022. This has occurred as inflation has hit multi-decade highs in major economies such as the UK, US and Germany and interest rates have risen sharply. Within the UK stock market, there has been a significant dispersion of returns. Investors have displayed a clear preference for the larger, more international FTSE 100 companies. The extent of the underperformance of small and mid-caps (“smids” for short) is rare and, in the past, such periods have usually been followed by longer spells of outperformance. Here, we explore the current outlook for this part of the market and explain how two Schroders investment trusts are positioning to benefit.

The UK smids market encompasses more than 1,000 companies. They may be less well-known than the household names that form the FTSE 100, but that doesn’t mean they’re not world-leading companies capable of generating superior returns. There are plenty of well-run, innovative and disruptive small and mid-sized businesses in the UK, with market-leading positions in new and emerging industries.

While this is normally an enticing blend of characteristics, in general terms, 2022 has not been a good year for UK smids. This part of the market is more domestically-exposed than the FTSE 100, which is dominated by large, internationally diversified businesses¹. These larger companies conduct much of their trade in US dollars and have benefited the extraordinary strength of that currency, which has provided a translational boost to profits that are reported in pound sterling. In turn, this has provided support to the share prices of larger, global-facing businesses, whilst the more domestically-focused smids have succumbed to the broader weakness in equity markets globally.

UK smids, as measured by the Numis Small Cap plus AIM ex IT (investment trusts) index, have fallen by 21% year-to-date². In comparison, the FTSE 100 is up more than 6% on the same basis, with the largest of its constituents benefiting from the strength of their dollar earnings, and their perceived safety in a world of uncertainty.

Recovery prospects

The acute underperformance of UK smids is piquing the interest of a variety of investors as they look to 2023. Over the past three decades, it has been statistically rare for UK smids to underperform to the extent that they have this year. When it has occurred, a period of strong outperformance versus the FTSE 100 has usually followed. Historically, buying UK smids on weakness has delivered positive long-term results, as illustrated by the chart below.

In part, this is because underperformance often leads to more attractive valuations. Starting valuation is one of the most important determinants of long-term investment returns and the current dividend yield of around 3% offered by the FTSE 250 index – the most established group of UK quoted smids – implies a potentially more attractive entry point for investors, and the presence of mispriced opportunities that were not available a year ago.

Meanwhile, with a longer runway of growth ahead of them than many of their larger counterparts, investing in small and mid-sized businesses over the long term should ultimately deliver superior performance. Many academic studies have evidenced the premium returns on offer from smaller companies. Indeed, the UK has a better track record than the US at delivering long-term success from this part of the market³. Importantly, this superior growth potential is now available at a more attractive price.

Opportunity knocks

It can be argued that UK stocks are cheap for a reason, and economic and political events have clearly undermined confidence in 2022. Nevertheless, it is always worth remembering that it’s during challenging and uncomfortable periods that opportunities can be most plentiful.

Some of the domestically-focused opportunities in particular look to be pricing in a lot of bad news. The opportunity set is broader than this, however. Sue Noffke, Head of UK Equities and portfolio manager of the Schroder Income Growth Fund plc, sees a diverse range of attractive opportunities across both domestic and global-facing UK smids:

“We see opportunities in both the ‘domestics’ serving the UK consumer and business end user, and the many internationally-focused smids. There is no silver bullet to the issues facing the UK economy, where more than 20% of the working age population is economically inactive. Valuations, however, are very beaten up and the market does not seem to be discerning between the good and less good companies.”

Ultimately, some of the higher quality businesses in this part of the market may prove vulnerable to bids. US buyers paying in dollars have a distinct currency advantage, which makes many UK businesses look appealing from a valuation perspective. Mid cap companies may be in the sweet spot here, as Andy Brough, Head of the Pan-European Small and Mid Cap Team and co-manager of the Schroder UK Mid Cap Fund plc explains:

“Should we see a resumption of bids for cheap UK assets, mid cap companies can be the target of choice – not too big, but sufficiently large to make a difference for the acquirer. As companies are taken out it helps make room for the next tranche of exciting FTSE 250 entrants (only around 20 of the original constituents from 1999 are still in the index today) helping to create a dynamism perhaps not there in other areas of the market.”

Schroder UK Mid Cap Fund plc

As the name suggests, the Schroder UK Mid Cap Fund plc may be viewed as an attractive way of accessing the opportunity in UK smids. The highly experienced team, led by Jean Roche, views the UK mid cap investment universe as the source of the UK’s star businesses of tomorrow. The team has a successful track record of investing in high potential UK smids, capturing their growth as they fulfil that potential, before they eventually become big enough to join the FTSE 100. Clearly not all opportunities will ultimately enjoy this growth trajectory, but overall the Company has delivered a return of 9.8% per annum since Schroders became Managers in 2003⁴. Past performance is not a guide to future performance and may not be repeated.

The team looks to build a high conviction portfolio of 40-50 resilient companies that are capable of delivering dependable long-term growth in cash flows and earnings. Innovation and disruption are constant themes within the portfolio. The managers are not complacent about the economic challenges, but they are confident that the disciplined investment approach that lies behind the Company’s long-term success continues to deliver a portfolio capable of capturing the attractive opportunity that lies ahead. As Jean Roche commented in the recently published annual report:

“As stock pickers, we are confident that the collective strength of our holdings’ balance sheets will provide resilience in a challenging economic environment. We are sticking to our sell discipline, avoiding companies whose business models are in danger of being disrupted while seeking out companies which have the ability to reinvent themselves, or which might be the next mid cap disruptor.”

Schroder Income Growth Fund plc

The current attractive opportunity in UK smids can also be embraced by portfolios with a broader mandate. Take the Schroder Income Growth Fund plc, for example. Managed by Sue Noffke, who has more than 20 years of investment experience specialising in UK equities, the Company has raised its dividend every year since its launch in 1995⁵, making it an attractive proposition for income-seeking investors.

It may invest anywhere across the UK market cap spectrum and the portfolio has a bias towards larger companies. Nevertheless, the investment opportunity in UK smids is well represented within the current strategy, with more exposure to this part of the market now than ever before. Indeed, in her role as Head of UK Equities, Sue confirms that the opportunity is being embraced across practically all of Schroders’ UK investment strategies right now:

“My colleagues across various investment teams at Schroders, whether they follow a ‘growth’ or ‘value’ style of investing, are seeing opportunities in the UK smids for a reason. I blend both styles and the portfolios run by me and my direct team are as exposed, or ‘overweight’ UK smids as we’ve ever been in 16 years running these funds.”

Conclusion

There is clearly an exciting opportunity among UK small and mid-sized companies currently, but as is always the case in the world of investment, it is not without risk. The war against inflation is far from over. Even the best companies are struggling to pass on their higher costs to a UK consumer facing a cost of living crisis of historic proportions.

Higher interest rates could be a major issue for companies with high levels of borrowings, especially if that debt needs to be refinanced over the next couple of years. However, many of the best UK smids have made it through the pandemic and, with the support of strong balance sheets and attractive starting valuations, they are well prepared to weather whatever storms lie ahead.