A burgeoning recovery in UK smaller companies could have further to run given imminent interest rate cuts, steady economic growth, and a more stable political backdrop, according to the Association of Investment Companies (AIC).

The trade body said its UK Smaller Companies sector returned 25% over the past 12 months to 22 July, making it one of the best-performing sectors, although it believed that investors had not missed the boat as the lower end of the UK market offered considerable value having been out of favour with investors for at least three years.

Comments from fund managers collected by the AIC underlined this point.

Roland Arnold, manager of the £729m BlackRock Smaller Companies (BRSC ) trust, said that valuations in the UK small and mid-cap sectors were ‘about as attractive as we have ever seen’. 

Combined with an improving economic backdrop – including a return to GDP growth, low unemployment, strong corporate balance sheets, and falling inflation – this all points to an earnings recovery and the attractiveness of the sector.

Stuart Widdowson, manager of £228m Odyssean (OIT ), is also expecting earnings to rally as in many cases profits are ‘close to, or at, a base level’.

‘Markets are forward-looking and will anticipate an earnings recovery before it happens,’ Widdowson said.

Takeover targets

The main buyers of smaller companies listed in the UK over the past two years have been corporate and private equity bidders as they swooped on undervalued businesses, further illustrating just how cheap the UK market has become.

Widdowson said that historically there was ‘always a public market premium – or private market discount’.

‘From this point, we believe that public equities will perform well against private equity over the medium term and the private market valuation discount will reappear,’ he explained.

Ken Wotton, manager of Strategic Equity Capital (SEC ), said that the steady stream of takeovers from UK companies at ‘elevated premia’ showcases the exciting opportunities in the sector.

‘Economic conditions appear to be improving with inflation lower, confidence recovering and the prospect of rates falling later in the year,’ Wotton said.

‘There are a large number of high-quality UK smaller companies trading at discounted ratings which bodes well for future returns.’

A change in fortunes for open-ended smaller company funds will also have a bearing on trusts operating in the same area.

Widdowson, whose small and micro-cap trust trades a premium of 2.2%, said the slowdown could see ‘a material rerating and reappraisal of the sector’.

‘We think it is well overdue and, when it happens, it will be sharp – a bit like pulling a brick across the table with a piece of elastic,’ he said.

Risks remain

While managers are bracing for an ongoing rally in UK smaller companies, the sector is not without its risks and Richard Staveley, manager of the £88m Rockwood Strategic (RKW ), said rising interest rates would ‘be a disaster’ as would any removal or reduction in tax incentives to invest in the UK.

‘I look forward to the opposite – falling interest rates and new incentives such as the British ISA,’ Staveley said.

Widdowson argued that the sector needs to ‘attract and retain public companies’ and the changes to the listing rules – which give more power to company bosses to make decisions without asking shareholders – are a start.

Arnold, meanwhile, remains cautious about the areas of UK small-caps that he invests in, and said there is ‘still fragility in certain sectors of the market’.

‘We believe that many of the factors that have held back UK smaller companies in recent years appear to be stabilising or reversing,’ Arnold explained.

‘Historically, periods of heightened volatility have been followed by strong returns and have presented excellent investment opportunities.’

Shares in all three trusts have seen their ratings strengthen in recent weeks. BlackRock Smaller Companies stands 8% below net asset value (NAV) against a one-year average discount of 11.6%. Rockwood Strategic and Odyssean have both seen their share price premiums increase, rising to 5.9% and 3.4% over NAV, although that is unusual in a sector where shares on average trail 12% below asset value.