Finding quality in UK small caps

The FTSE Small Cap Index was initially a beneficiary of the ‘reopening’ trade in 2021 and outperformed the FTSE All-Share by over 15% up until the end of August. More recently, however, the index has struggled amid concerns over domestic labour shortages, supply chain disruption, elevated energy and freight prices.

Domestic consumer and value stocks have started to underperform as a result, and this rotation back in favour of quality and growth (away from leverage and cyclicality) has generally helped in our small cap strategy.

The strategy focuses on ensuring that the fund’s long-term holdings demonstrate key fundamental attributes – SIMBA (Scalable business models, Innovative products or service, proven and aligned Management, Barriers to Entry, unique Assets). We believe that an approach focusing on these attributes should identify companies that are well positioned to either pass on price increases or innovate to improve efficiencies, reduce costs and to take share within markets. In addition, the strategy invests in companies which have secular tailwinds in their addressable markets, and many of these tailwinds have accelerated since the Covid outbreak.

A good example of this is Kin and Carta (KCT), a digital transformation group and one of the fund’s largest holdings. KCT reported impressive full year numbers recently, increasing forward guidance to over 30% organic revenues growth as the business helps corporates navigate towards cloud-based software systems and architecture.

Another example is food producer Hilton Foods. The group has invested in automation technology that reduces the number of manual pickers in a facility from over 100 to just eight. At the same time, we look to avoid companies with an unfavourable balance of power, for instance those reliant on high capital intensity, that have no pricing power, or that are overly leveraged. These companies are unlikely to be able to protect margins by passing on cost inflation to their customer base and will thus see margins squeezed.

In overall terms, we believe that this approach can still create a well-diversified portfolio, but one with a clear bias towards quality, as can be seen in the table below. Higher returns on equity, higher EBIT margins and significantly higher earnings growth demonstrate that these fundamental attributes result in better earnings, while the strategy’s focus on highly cash generative companies with balance sheet optionality is seen in the lower net debt multiple. Given the heightened uncertainty at present, we believe that this approach of investing in high quality companies who are in control of their own fates, is the right one.

Source: RLAM, as at end October 2021

Past performance is not a reliable indicator of future results. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.

The Royal London UK Smaller Companies Fund is a sub-fund of Royal London Equity Funds ICVC, an open-ended investment company with variable capital with segregated liability between sub-funds, incorporated in England and Wales under registered number IC000807. The Company is a UCITS umbrella fund. The Authorised Corporate Director (ACD) is Royal London Unit Trust Managers Limited, authorised and regulated by the Financial Conduct Authority, with firm reference number 144037. For more information on the fund or the risks of investing, please refer to the Prospectus or Key Investor Information Document (KIID), available via the relevant Fund Information page on www.rlam.co.uk.

The RL UK Smaller Companies Fund (“the Fund”) has been developed solely by Royal London Asset Management Limited. The “Fund” is not in any way connected to or sponsored, endorsed, sold or promoted by the London Stock Exchange Group plc and its group undertakings (collectively, the “LSE Group”). FTSE Russell is a trading name of certain of the LSE Group companies. All rights in the FTSE Smaller Companies ex IT index (the “Index”) vest in the relevant LSE Group company which owns the Index. “FTSE®” is a trademark of the relevant LSE Group company and is used by any other LSE Group company under license.

The Index is calculated by or on behalf of FTSE International Limited or its affiliate, agent or partner. The LSE Group does not accept any liability whatsoever to any person arising out of (a) the use of, reliance on or any error in the Index or (b) investment in or operation of the Fund. The LSE Group makes no claim, prediction, warranty or representation either as to the results to be obtained from the Fund or the suitability of the Index for the purpose to which it is being put by Royal London Asset Management Limited.