Two reasons to consider investing in UK smaller companies, August 2017

As Britain steps up the pace of Brexit negotiations in an attempt to reassure businesses, we take a look at why UK smaller companies may be an attractive investment opportunity, despite the apparent risks of a messy 'divorce'.

A reversal of fortunes for the pound

According to Ed Heaven of Montanaro Asset Management, the first reason to be optimistic about the outlook for UK smaller companies is currency. Since we voted to leave the European Union, sterling has fallen by 15% versus the euro. The beneficiaries of this move have been exporter companies, which is one reason for the dramatic underperformance of UK smaller companies relative to the FTSE 100 last year: investors shifted into multinational companies that sourced earnings from overseas.

As Ed points out, if you believe in mean reversion, then it is possible to argue that at some point this will reverse. On a trade weighted basis, the pound has rarely been as low as it is today. Indeed, its current level proved the currency’s bottom in February 1993, December 1995 and January 2009. There is then, some historical basis for believing that sterling could rise from here. If this were to happen, the main beneficiaries would likely be domestic companies, at least on a relative basis.

Better value

The second point worth bearing in mind, in Ed's view, is valuation. Given certain markets are at, or near, record highs, it is natural that investors are getting a little nervous about valuation levels. Will markets continue to rise and get more expensive? Or is a correction imminent?

While the FTSE SmallCap index – like the FTSE 100 – is near all time highs, it is also on the widest P/E discount to the FTSE LargeCap index since the start of the millennium - some 34%*. So while this area of the UK stock market is not cheap, it does represent the better value compared with its larger peers.

Chelsea fund ideas

Montanaro UK Income fund is on the Chelsea Selection.

Our favoured UK smaller companies funds are AXA Framlington UK Smaller Companies, Franklin UK Smaller Companies, Liontrust UK Micro Cap, CF Livingbridge UK Micro Cap, Marlborough Special Situations, Marlborough UK Micro Cap Growth and R&M UK Equity Smaller Companies.

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Ed's views are his own and do not constitute financial advice.

*Source: Montanaro Asset Management, On the beach: two things to consider, 10 August 2017.

Published on 16/08/2017