2023 has been the continuation of a steep uphill struggle for UK smaller companies. Sticky inflation, interest rates set to remain higher for longer, febrile markets, geopolitical crises and rising fears of recession in Europe paint a pretty bleak picture for small, growth-focused businesses - certainly enough to turn many potential investors’ stomachs.
However, there is an alternative, more optimistic story to be told, says Georgina Brittain, portfolio manager of JPMorgan UK Smaller Companies Investment Trust (JMI) – and it’s a compelling one.
An optimistic story on UK economic performance
There are a number of strands to her argument. First, as recent Office of National Statistics (ONS) upward revisions to GDP data show, UK economic performance since Covid has been significantly stronger than previously thought.
UK GDP for the second quarter of 2023 was believed to be 0.2% lower than pre-pandemic levels; following the revisions it’s now estimated to be 1.8% above. As Brittain observes: “We should no longer be seen as a massive outlier in terms of economic recovery.”
Secondly, real wages growth has finally turned positive as consumer price inflation has eased, and that has fueled a rebound in consumer confidence as measured by the GfK Consumer Confidence Index (though it has been knocked back somewhat recently by concerns around the Israel/Gaza conflict).
Thirdly - and often overlooked in these discussions – ONS data indicates a significant recovery for business investment in the UK, up 7% over investment levels a year ago.
A further important factor is that British companies operating defined benefit (final salary-type) pension schemes for their employees have seen their liabilities improve significantly as interest rates have increased.
“It sounds esoteric, but many companies are paying a lot of their cash flow into their pension schemes,” explains Brittain. “Rising interest rates have enabled some to get their schemes into surplus and sell them on, freeing up more cash.”
Share buybacks are another factor. This used to be very much a US phenomenon, she says, but it has gained a lot of traction this side of the pond, helping to maintain share price stability and boosting investor confidence.
“The number of UK companies buying back shares is larger than it’s ever been,” Brittain points out. “As smaller company investors, we would much rather the cash was invested for further growth rather than being used for buybacks – but given current low valuations it’s hard to argue against them.”
Finally, she highlights the importance of government (and opposition) support, with numerous initiatives such as the Mansion House Reforms, which aim to support growth across the economy, collectively working to help reinvigorate the UK equity market.
Some of the best equity returns in the world over multiple decades
Beyond the economic arguments, it’s also worth reiterating the historical attractions of the UK’s mid and smaller cap companies for investors. “The FTSE 250 and small caps have produced some of the best equity returns in the world over multiple decades - yet they are undoubtedly very out of favour now,” observes Brittain.
Not only is the UK market extremely cheap, but smaller caps are even cheaper – yet their estimated median earnings growth for 2024 is getting on for 50% higher than that of the blue chips, according to investment bank Peel Hunt figures published in October.
At the same time, there are fewer research analysts covering the market generally, and particularly the smaller-cap end.
Research provider Liberum found an average of 16 analysts covering FTSE 100 companies, compared with just eight looking at the FTSE 250, and fewer still at smaller businesses.
Given the extensive in-house analyst resources at JPMorgan, that’s a particular selling point for JMI as a mid and small cap manager, says Brittain. “We’ve got great internal analysis and we’re able to find the companies that the larger market is ignoring because they’re too small.”
The Trust’s strategy has paid off in long-term performance
The trust’s focus on companies offering outstanding value, high quality and positive momentum remains evident in a range of balance sheet metrics relative to the benchmark index (Numis Smaller Companies plus AIM ex ITs).
But it’s in terms of value that JMI’s current position stands out most starkly. The team uses both the price/earnings ratio and free cash flow yield (which compares expected free cash flow with share price) as key indicators of the cheapness of portfolio companies. As of 30 September, its free cash flow yield stood at a meaty 7.5%, twice that of the benchmark.
“This is absolute distress territory, but we’re just not recognising that in the experience of the companies we invest in, nor in the wider small-cap market,” stresses Britain.
At the same time, JMI’s quality in terms of return on invested capital, at 14.6%, sits well above the benchmark’s 9.4%, while momentum is also well ahead of the wider market.
That continuing firm focus has clearly paid off for Brittain and the team after a very difficult 2022, despite the wider economic and market challenges. Over the year to end September, JMI saw gains of almost 10%, compared with just 3.3% for the benchmark.
While the three-year annualised returns were held back by the difficulties of 2022, level-pegging with the benchmark, those for five and 10 years are both comfortably ahead.
Indeed, it’s hard to fault the long-term record: even taking into account last year’s steep falls, JMI is up more than 400% since 2009 - more than 150% ahead of the benchmark index.
With that track record, the current situation, compounded by a 14% share price discount to net asset value looks like it could offer an extremely attractive entry point for long-term investors keen to access the large, diverse and dynamic smaller companies arena.
Note: On 14 November 2023, after this article was written, the Board of JPMorgan UK Smaller Companies Investment Trust plc announced a proposed combination with JPMorgan Mid Cap Investment Trust plc.
The Boards of both companies believe that the transaction will create a larger, more liquid investment trust providing shareholders with continued exposure to the exciting UK Smaller Companies arena. Shareholders will also benefit from a reduction in costs, contributing to the good potential for capital growth, and a new enhanced dividend policy, which will allow them to benefit from an attractive yield. Documentation in relation to this transaction is expected to be published in January 2024. In the meantime, both companies’ shares continue to trade as normal. For more information, see JPMorgan UK Smaller Companies Investment Trust plc, and JPMorgan Mid Cap Investment Trust plc