UK smaller companies - where next?

Henry Lowson, Head of UK Alpha Equities at RLAM and lead fund manager for the UK Smaller Companies and Mid Cap Growth Funds, reflects on 2021 and discusses the opportunities that lie ahead.

How was 2021 for UK smaller companies?

2021 saw UK smaller companies once again come out on top, ahead of their larger cap peers, with the FTSE Smaller Companies ex-IT index returning over 30% – a stellar year by any standards and the second year in a row that this asset class has outperformed the larger FTSE All share. It is a shame many asset allocators have missed out on these returns as UK equities continue to experience outflows.

However, it was a year that despite the positive headline result was fraught with danger. The first quarter saw a violent style rotation and a lurch towards cyclical and value-oriented stocks (those with cheaper headline Price Earnings (PE) multiples) and away from more highly valued growth stocks. Domestic companies, recovering from the travails of Covid-19 induced lock downs also performed strongly as consumers started to spend some of their increased savings on home improvements and other big-ticket items. The following three quarters of the year saw another market style rotation as growth stocks started to reassert themselves again; earnings upgrades were delivered, capital investment was cranked up and monetary policy remained expansionary. Significant hurdles of cost inflation and supply chain disruption (respectively compressing margins and restricting revenue growth) had to be overcome as companies struggled to cope with an acceleration in demand at a time when many economies were still flipping in and out of lockdown.

How has the market been so far this year?

2022 has experienced a similarly violent start so far, but rather than chase style rotations or attempt to predict future macroeconomic events, we continue to believe that our time is best spent analysing the fundamentals of companies, and it is these that assert themselves over our long-term investment horizon (3-5 years). We focus on five key fundamental attributes in particular – Scalability, Innovation, Management, Barriers to Entry, unique Assets (SIMBA). We call this process SIMBA because, like the Disney Classic, we believe that companies that exhibit these fundamental characteristics will go on to become roaring large cap lions!

This year we are faced with the prospect of further elevated cost inflation, supply disruption (although improving) and higher discount rates, so the ability of companies to pass on higher costs and innovate will be critical to maintaining profit margins and growth. Companies that exhibit these fundamental attributes will be best placed to do this.

Which stocks performed particularly well last year?

One of the RL UK Mid Cap Growth Fund’s best performing stocks in 2021 was Watches of Switzerland, the luxury watch retailer, which almost tripled to just under £15. The fund took a holding at the Initial Public Offering (IPO) at £2.70 in June 2019 and in the depths of 2020 (during the worst of the pandemic) the stock was trading as low as £1.80. The market had grown concerned about the exposure to tourism and retail shop closures. In fact, the market underestimated that high end watches are a supply constrained market – there is a fundamental imbalance of demand over supply (Rolex waitlists, in some cases, are several years long). Watches of Switzerland is a well invested, specialist retailer of luxury watches and as such is a favoured channel for key brands including Rolex and Patek Phillipe. As a result they are allocated preferential stock. The company has a dominant position in the UK and are busy replicating their strength in the US, where the penetration of high-end watches is half that of the UK. Management was particularly adept, during the crisis, at ‘clientelling’ – selling over video calls and the telephone to their extensive list of high-net-worth clients.

What challenges do smaller companies face this year?

As we stare into the crystal ball that is 2022, bears will point to higher discount rates as being the barrier to equity market performance (particularly for growth stocks) but there are plenty of examples of strong equity returns made in years when interest rates have risen (e.g., 2017 and 2003-2006). All else being equal, rising interest rates often signal stronger economic growth, and UK GDP growth in 2022 is still expected to remain robust at over 4.5%. In fact, as we have alluded to in previous reports, it is our belief that many small and mid-sized companies have, post pandemic, an opportunity to accelerate their growth. We believe this is driven by themes such as innovation/automation (leading to productive efficiencies), the focus on supply chain security by corporates (resulting in market share gains for well diversified/well invested suppliers), infrastructure investment (a consequence of supportive and expansive government budget stimulus) and changes in the way of living (increased home improvement/leisure spend) to name a few. These higher future cashflows will more than offset the theoretical compression in valuations from higher discount rates, in many cases, such that valuations remain attractive today.

Are smaller companies a good place to invest in 2022?

Some commentators believe that valuations are currently elevated. However the differential between the earnings yield, that can be achieved through investing in equities, and the yield on corporate debt, is almost as high as it has ever been (a bullish signal). Furthermore, profits growth could well surprise on the upside as management teams have erred on the side of caution with regard to guidance for 2022, despite a strong finish to 2021. I have lost count of the number of companies that in Q4 upgraded earnings guidance for 2021 but did not roll this higher base forward into 2022 earnings.

We believe that a diversified, liquid, stock picking portfolio invested in profitable and cash generative companies with strong balance sheets is the best way to mitigate some of the risks we face as investors in this asset class. For those willing to take a long-term view, there are potentially very high returns on offer and we believe we have a structure and investment process to uncover them.

Past performance is not a guide to future performance. Portfolio holdings are subject to change, for information only and are not investment recommendations. 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 value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested.

The Royal London UK Smaller Companies Fund and Royal London UK Mid Cap Growth Fund are sub-funds 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 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.