As the three-year anniversary of the EU referendum approaches, we are no closer to knowing detail of the type, if indeed any, of exit the UK will eventually make. Uncertainty, as a result, looms large.
But take a step back, look at the broader picture, and it’s not hard to be positive about the UK small cap investment opportunity set.
The Numis Smaller Companies (ex ITs) Index is trading on a forward P/E multiple of 11.5x, below its long-term average of 13x, with consensus earnings growth expectations of 6-7%1. Meanwhile, the Merian UK Smaller Companies Fund is trading on a forward P/E multiple of 14.5x, with earnings growth of 10%2. Yes, the portfolio is trading at a premium to the market but by no means do valuations look stretched; indeed, the portfolio is very much in line with its historical valuation.
Waiting for certainty
Last year heralded a change in the global economic environment as desynchronisation came to the fore, a reversal of what was seen in 2017. The Eurozone continues to flirt with recession; China is struggling to maintain growth at the same level; while the US tax cut tailwind has eased. However, reasonable global growth is on offer and a global recession is not on the cards.
In the UK, headline GDP growth may remain below trend but beneath the surface, the key drivers of the economy remain in good health: employment numbers are strong with the unemployment rate sitting pretty at 4% and the participation rate at a record high. Meanwhile, real wage growth has turned decisively. These are powerful forces.
Government finances are as healthy as they have been since the Global Financial Crisis, with the deficit at 2% and falling, record tax receipts and borrowing consistently undershooting expectations3.
Yes, business investment remains the elephant in the room – it fell 4% in 20184 – but weakness in this area can be placed fully at the door of political uncertainty; uncertainty that we hope and expect to be temporary. When Brexit certainty does come, the current headwinds should quickly become tailwinds. As far as we are concerned, from an equity market perspective, anything but no deal represents a positive outcome.
In the past year we have made gradual tweaks to the balance of the portfolio, trimming our overweight position in structural growth and reducing the degree of our underweight position to UK domestic cyclicals, an area of the market that has underperformed since June 2016. Selectivity, though, is key and we have been focusing on those areas of the retail sector relatively immune from the trend of internet disintermediation. Those businesses in this area that are not structurally challenged and are trading at attractive valuations are well set to thrive should a benign Brexit outcome be forthcoming.
Examples of such businesses include Dunelm, the home furnishing retailer, Lookers, the car dealership chain, and DFS, the furniture retailer with a 30% market share in the UK.
As things stand, our exposure to domestically focused businesses is at 55%, versus 45% to internationally focused ones (our index by contrast is weighted 60:40 in favour of UK domestics). In the aftermath of the referendum, we were closer to 50:50.
Of course, it remains all-important to follow the politics but we have laid the foundations for what we expect to come next. Right now, it is hard to see through the fog of Brexit but when it lifts, if should reveal attractively valued companies with solid fundamentals.
We are positioned to take advantage.
1 Peel Hunt as at 25 March 2019
2 MGI, 25 March 2019
3 Office for Budget Responsibility, 25 March 2019
4 Office for Budget Responsibility, 25 March 2019