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Surprisingly strong performance from UK smaller companies since Brexit vote

Today marks the second anniversary of the European Union referendum, with negotiations on Brexit continuing and controversy raging over the say of Parliament in the final agreement.

But expectations of a collapse in UK-focused investment appear – so far – to be unfounded, as new analysis shows a surprisingly strong performance from UK smaller companies since the vote.

Since June 2016, the FTSE Small Cap Index has produced an average return of 38.38 per cent, compared to 31.41 per cent from the FTSE 100, according to data from FE Analytics.

Fund managers specialising in these companies have done even better. The Investment Association’s UK Smaller Companies sector returned 48.62 per cent over the same period, beaten only marginally by the IA European Smaller Companies sector.

The data has confounded forecasts that the FTSE 100 would perform best post-referendum, after sterling plunged benefitting international earners. Experts at the time believed smaller companies would be hit by an economic downturn, since they are more domestically-focused than their mid-cap and larger peers.

“Small-caps were beaten up in the run-up to the referendum and, at one point, were sitting at a hefty 20 per cent discount relative to the FTSE 100”, says Darius McDermott, managing director of CHlsea Financial Services. “But when investors realised that the UK economy may not be doomed after all, this discount shrunk – it is around 10 per cent today – as they snapped up the stocks which had unfairly been tossed in the bargain bin.”

Some fund managers argue that a combination of excessive pessimism, good corporate debt management and increased merger activity bodes well for investors.

Neil Hermon, manager of Henderson Smaller Companies investment trust, said: “There’s a lot of bad news out there but wage inflation is picking up, unemployment is at a low level and consumer confidence isn’t as low as it could be.

“The UK market is cheap compared to international markets and this is being picked up by foreign corporate buyers. We are seeing a lot of mergers and acquisitions in UK thanks to cheap debt and strong global balance sheets, and this should continue.”

He also argued that UK plc was in “pretty good shape”, adding: “Corporate balance sheets look much better today than they did in 2008. In the past decade, corporates have used that time to generate cash to invest in their businesses and to reduce their debts.”

Other managers are less upbeat. Dan Whitestone of the BlackRock Throgmorton trust said: “Whilst many UK consumer shares appear cheap on metrics, like price to adjusted earnings, this fails to take into account the levels of debt and poor cash-flow some of these companies exhibit.

“In many cases, these same investments are also exposed to cyclical pressures, such as weakening demand from consumers or rising costs affecting profit margins, and structural pressures, from digital disruption to competition from low-cost rivals.”

But Mr Hermon emphasised the need to invest in businesses that trade abroad and can benefit from a relatively robust global economy. “Only half of sales in companies I own come from the UK, while half come from overseas.”

Georgina Brittain, co-manager of the JP Morgan Midcap investment trust, said: “Our biggest concern for UK-facing stocks was that companies would stop investing. Some said they would put projects on hold, but many of these have now taken place. There has been a hiatus but not a collapse.”

However, UK midcaps have had the toughest time post-Brexit vote, with the FTSE 250 index underperforming the FTSE 100 and small cap index by 2.27 and 9.14 percentage points respectively. Ms Brittain admitted that she conducted a “significant reshuffle” towards global-facing stocks following the vote and assumed a hard Brexit outcome.

She added: “We emphasised exporters and overseas earners in the portfolio and decided to reduce our exposure to stocks that depended on the UK consumer. Two years on and we have stuck to that approach.”

While past performance is not a guide to the future, recent research from the AIC found that UK-focused investment companies have proved to be the most reliable performers over the past decade. Investment trusts focused on smaller companies made up a quarter of the list, compared to global trusts comprising one fifth of the top performers.

Annabel Brodie-Smith, AIC communications director, said: “Concerns about Brexit and a UK economic slowdown are ever present, but UK investment companies, and particularly the UK Smaller Companies sector have performed consistently well.

“Investors should bear in mind that performance is just one of the criteria to consider when researching investment companies. They also need to look at portfolio composition, gearing discounts and charges. Investors usually focus on the latest top performers but consistent long-term past performance is key when considering potential investment companies.”

Source : HeraldScotland

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