UK small-cap view: Lower valuations could drive M&A activity

Architas advent calendar – 12 December

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Continuing our countdown to Christmas, Richard Bullas discusses recent small-cap underperformance against the broader market and the prospect of a period of increased M&A activity in the new year

The small-cap bull market that began in the early summer of 2012 had largely run its course by mid-2014, with many stocks enjoying dramatic reratings during this period. In the last couple of years relative performance has been more muted, with 2016 a particularly difficult year.

The good news, however, is that this recent relative underperformance against the broader market means an attractive valuation gap has opened up, with UK smaller companies typically trading on a 15% to 20% valuation discount to their larger peers.

The valuation gap can be explained by a number of factors, the most obvious of which are the liquidity premium for larger companies and the greater domestic content in small-cap earnings at a time of heightened uncertainty regarding the UK economy.

Given the decision to leave the European Union, the UK is likely to experience an economic slowdown in 2017, though it will once again be the most dynamic of the major economies in 2016, with GDP growth of close to 2%. We believe growth will be in the range of 1% to 1.5% - ‘slower' growth, not ‘no growth', and certainly not a recession.

From the perspective of a small-cap investor, it is important that growth is sufficient to give management teams the confidence to continue to develop their businesses. One of the prime attractions of the small-cap asset class is the sheer breadth of opportunity from an investable universe of more than 1,000 stocks.

Many of these will flourish whatever the macroeconomic backdrop. The asset class will, however, be much more interesting and potentially more profitable for investors if business leaders are still making decisions, buying and selling businesses and moving forward with investment plans. This will only happen if confidence holds up.

Increased M&A

Small-caps are a dynamic asset class and this again is an important attraction to investors. New listings can provide interesting investment opportunities and takeovers enable value to be realised.

We see the new issue market becoming busier in 2017 after a hiatus in recent months and believe the relatively low valuation of small-cap stocks may well herald a period of increased merger and acquisitions activity in the new year.

Fund flows are another important driver of smaller company valuations and have provided a headwind in the second half of 2016 since the UK referendum. We are hopeful we will see a return to net inflows in 2017 as asset allocators become more comfortable with the economic outlook and focus more attention on the valuation opportunity.

Small-cap investing has always involved a trade-off between greater risk and greater reward. This remains as true today as ever but we are optimistic that, following a somewhat difficult 2016, there are better times ahead.

Richard Bullas is portfolio manager of the Franklin UK Smaller Companies Fund

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