The UK economy may still be in the early stages of a recovery, but if stock markets are indeed leading indicators, the UK smaller companies market may be offering some good news for investors.

The portfolio managers of the JPMorgan UK Small Cap Growth & Income plc (JUGI) see a number of signs that may be pointing to recovery—including strong performance from small cap stocks over the past 12 months. What’s more, UK equity valuations are still highly attractive, especially if the economy continues to strengthen.

The UK economy is recovering

The domestic economic outlook is one of the most important drivers for smaller companies because so many smaller businesses depend on the domestic economy for their business operations.

The good news is that a number of economic indicators appear to be improving. The GfK measure of consumer confidence is increasing and consumer price index (CPI) inflation, which spiked severely in 2023, has come back down to more normal levels. The purchasing managers’ indices (PMIs) show that the UK economy is expanding again and households appear to have increased savings, potentially a function of higher wages and indicating a healthy consumer.

Valuations are attractive

The UK equity market, including small caps, looks inexpensive; the market is trading at over a 40% discount to the US equity market, when looking at price to 12-month forward earnings and the valuation discount to European stocks has also widened. The UK market also looks inexpensive on free cash flow yield.

It’s not just JUGI’s portfolio managers that think UK small cap stocks look cheap. Companies have been increasingly buying back their own stock. While JUGI’s portfolio managers have typically favoured investing in companies that are paying special dividends to shareholders, which are especially positive for investment trusts, current valuations are so attractive that they can’t think of anything more profitable than companies buying back their own shares.

Merger and acquisition (M&A) activity in the UK market has also picked up significantly from the low level of activity a year ago, signalling that corporate managements also think UK smaller companies are attractively valued. JUGI has benefited from several transactions, where corporate buyers have paid premiums for a few companies held in the portfolio.

Positioning for a positive outlook

JUGI’s portfolio managers are positive on the outlook for the UK economy and UK smaller company stocks. The relative health of the UK consumer supports many of the portfolio’s holdings in the household goods & home construction sector, the trust’s largest overweight sector position. The portfolio managers have been particularly keen on the housebuilding industry where they maintain a position in MJ Gleeson. And although the repair, maintenance and improvement (RMI) market has been weaker, the trust’s holding in Volution has been delivering growth, benefiting from a new regulation related to ventilation in the residential market.

The managers’ positive view on the consumer flows through to positions in travel and leisure companies, such as Hostelworld, which is benefiting from some investments in technology. The trust also has an overweight position in banks, including Paragon, which is taking market share from some high street banks.

The ability to use gearing, currently at 10%, is another way JUGI’s portfolio managers can express a positive outlook.

Evolving portfolios for the long term

JUGI reflects the merger of JPMorgan UK Smaller Companies Investment Trust plc with JPMorgan Mid Cap Investment Trust plc, completed at the end of February 2024. The resulting portfolio is now twice its size from the beginning of year. The strategy still focuses on smaller cap stocks but also has flexibility to add positions at the low end of the mid cap range. The trust now has a stated policy to pay 4% of NAV per annum, with 1% paid each quarter.

Importantly, the investment philosophy remains the same. The portfolio managers look for opportunities with a combination of value, quality and momentum that have the potential to generate higher returns than the benchmark over time.