IFAM: With all the current economic, political and market uncertainty, in your view what is the outlook for UK Smaller Companies in 2020?
MC: While uncertainty around the ongoing Brexit situation, as well as broader political noise, is unavoidable, from my perspective little has changed: we have been living with political and market uncertainty in the UK for almost four years now.
Over those last four years I’ve spent a lot of time talking with company management teams about politics. Of course, companies are exposed in different ways and the various political/Brexit outcomes will affect them differently. In general, though, I think that UK companies are pretty well prepared for most eventualities. This is because companies are used to managing lots of risks. They constantly worry about things such as competition, product obsolescence, changes in regulation and so on. Their environment is always inherently uncertain. Brexit is therefore simply another thing to add to the risk register. Companies have been thinking and planning for this since long before the referendum in 2016 and putting in place their contingency plans. The mantra of ‘hope for the best but prepare for the worst’ is something which I hear time and time again. Of course, depending on the outcome of the general election and Brexit there will be winners and losers, but I don’t think we will see many absolute disasters. I also think that we will see continued growth from businesses which are innovating and doing things differently. This is something we see a lot in the small cap space and something that isn’t likely to end.
How the stock market thinks about this uncertainty is a slightly different matter, and of course there is scope for absolute share price declines in the short term. However, I believe that equity valuations today look very good value relative to other asset classes. UK equities currently sit at a significant discount to global equities in valuation terms. Recent data from Peel Hunt has showed global equities trading on a twelve month forward P/E of 15.3, the US market on a P/E of 17.3 and the UK on 12.2. Looking at smaller companies, there’s a further discount to this again. The NUMIS smaller companies index is currently showing a forward P/E of 11.1. In terms of UK smaller company valuations, it seems like we’re sitting on a discount to a discount to a discount. The challenge for investors is timing – how to balance the long term valuation opportunity against short term uncertainty.
IFAM: Where do you see the biggest opportunities in valuations and for growth within the sector?
MC: As a small cap investor, many of the businesses I look at are innovators and disruptors. I think that this is where growth has always come from and probably always will. When it comes to valuations, this is a little more complicated as these are tied into the overall macro situation. There is undoubtedly cheapness in UK domestic stocks. However, whether they ultimately turn out to be value or value-trap is going to depend on how things play out. My view is that it is possible to find pockets of value in sensible businesses which will have a strong future in any scenario. It is our job to identify those businesses and assess them properly using all the tools we have at our disposal.
IFAM: What do you see as being the biggest risks to performance at the moment?
MC: For many investors it can be easy to fall into the mind-set that the UK domestic economy is uncertain and therefore to be avoided. I suspect that there are many client portfolios at the moment which are skewed away from the domestic market and more towards international exposure.
The challenge with this approach is that risk works both ways. Having little or no exposure to the UK market is a risk in itself if we were to see a reasonably benign political outcome. Arguably, the bigger risk is having too little domestic market exposure rather than too much, as you have to ask yourself how much further valuations could fall from these already low levels.
IFAM: In the light of what we’ve discussed so far, how are you positioning the fund to take these factors into account?
MC: My approach is to consider these issues at a company level, rather than trying to predict their outcomes. This involves regular meetings with managers about their specific challenges and opportunities, and how they are mitigating risks.
I then look at how these issues might impact valuation. Sometimes the very cheap stocks are cheap for a reason, but there are other times when they have been swept up with general market sentiment. It is important to differentiate between the two.
At a portfolio level, my aim is to be reasonably neutral to the various political outcomes, rather than trying to position the portfolio one way or another. My investment process is entirely bottom-up and I want the portfolio to reflect that. Predicting the outcome of political events is not my skill set so I don’t want to introduce that risk into my fund. One of the interesting things about the result of the Brexit referendum and even more dramatically the election of Donald Trump in the USA was that the market didn’t behave in the way that many people thought it would. Trying to position a portfolio even if you have a strong view is therefore very challenging.
Portfolio construction is based on a sensible mix of businesses – domestic, international, cheap, expensive, and spread across a range of different sectors – exactly as I would do in any economic environment. This ensures the right level of diversification to protect investors as much as possible from extreme volatility. I can sum it up by saying that overall, my portfolio positioning and approach are pretty much what they normally are.
IFAM: How positive are you about the future prospects for growth from smaller companies?
MC: As I said before, one particularly positive thing for those of us operating at the smaller end of the market spectrum is that we see lots of firms which are focused on disruption and innovation. People often get hung up on UK economic growth rates, but a small, an innovative business growing at, say, 20% a year doesn’t generally care much about UK GDP. Fortunately, the positive nature of their business position and innovation rather overwhelms the background macro situation.
If we consider the long term history of smaller company performance in the UK these have performed incredibly well.
The Numis Smaller Companies MSCI Ex IC Index shows that with 63 years of data, smaller companies shares have delivered an impressive 10% per annum real return. When you have a corporate sector capable of this kind of growth, it can seem a little churlish to worry too much in the context of whether the overall economy is likely to grow at 1%, 2% or even -1% over the next twelve months.
I believe that the important thing is to remain focused on fundamentals. By carrying out our detailed research and analysis procedures we can continue to identify and invest in strong businesses which are capable of delivering attractive growth for investors for many years to come.
About Matt Cable
Matt joined Jupiter in 2019 and is fund manager of the Jupiter UK Smaller Companies Fund. Before joining Jupiter, Matt was at M&G for 11 years, during which time he was a member of the smaller companies team and was involved in the running of c. £850m of assets. He was also the lead manager of the M&G PP UK Smaller Companies Fund from 2014.