Uncovering Opportunities in the UK Small-Cap Market

The response from central banks to the economic fallout from COVID-19 has been nothing short of spectacular, but unknowns remain. Franklin UK Equity Team’s Dan Green explains how investor sentiment towards smaller UK stocks has swung between the extremes of panic and euphoria, and shares how this uncertainty can uncover opportunities in this space.

The Equity Market Pendulum

Over the last few months, we’ve witnessed investor sentiment towards small-capitalisation (small-cap) stocks swing between the extremes of panic and euphoria based on daily headlines, with prices often becoming detached from underlying fundamentals.

When widespread panic gripped global financial markets at the end of March, we saw indiscriminate selling of equities and the FTSE All-Share Index¹ plummeted to a new multi-year low. But when global central banks stepped in with liquidity injections, it sparked the biggest three-day rally we’d seen in decades. Suddenly, the companies in the sectors that were most exposed to COVID-19-related lockdowns attracted investor interest again as they looked inexpensive relative to prior valuation levels.

All of a sudden, the fear of losing money was replaced by the fear of missing out (FOMO) on potential profits. In hindsight, it turned out to be a very attractive entry point for many stocks in the short term.

A lot has changed since we last addressed developments in the small-cap market. In times like these, we believe it’s more important than ever to stay true to a rational investment process and focus on the long term and look beyond the  short-term headlines.

Some Companies Still Thriving amid Uncertainty

We can only describe the COVID-19 pandemic as a black-swan event. While many companies have faced challenges, others have been able to thrive during this tumultuous period, particularly those that are less sensitive to the economic cycle.

For our portfolios, we are particularly interested in companies that have displayed structural growth properties and have a recurring revenue stream, such as aerospace and defence and video gaming, among others.

It’s no surprise that COVID-19 has accelerated some existing trends, such as the increase in e-commerce activity and consumption of online content. For example, video gaming companies and gaming platforms have seen revenues and engagement surge during the past few months. As investors, we are alert to the potential disruptions for businesses during this period, and we will continue to monitor how recent consumer trends and working patterns will develop and persist. The potential permanent changes to business models in industries like retail, travel and office space providers creates opportunities along with threats.

The Central-bank Response and Remaining Unknowns

In response to the pandemic, the largest global central banks have expanded their collective balance sheets by over US$4 trillion.² Additional fiscal stimulus has boosted total worldwide stimulus today to roughly US$15 trillion, about 17% of the global economy.³

What’s unknown to us is the ability for central banks and governments to keep providing this level of stimulus, what this means for future tax rates and how this will affect the economic recovery coming out of crisis mode.

We are without a doubt in a major economic downturn. The Office for Budget Responsibility has forecast that the UK economy will likely shrink by 12.4% this year—which would be the largest decline in 300 years.⁴ However, what’s unknown is the speed and shape of the recovery coming out. Is it going to be V-shaped, U-shaped, or W-shaped? It is very difficult, if not impossible, to forecast how the recovery will unfold at the moment.

The number of confirmed cases of COVID-19 has been falling in the United Kingdom since the peak in April, but there is no clear indication how effective measures will be to suppress any emerging local outbreaks—which we have seen increase in recent days. Despite some encouraging early results from a number of potential vaccines, it is difficult to forecast the timing or efficacy and subsequent effect on the economy. Therefore, it would be foolish to position a portfolio purely based on the macroeconomic picture—which is still rife with uncertainties. Instead, we are focusing on the fundamentals of individual businesses, their business models and competitive positions.

As long-term investors, we think it’s important to look for companies that can not only survive this difficult period, but emerge in an even stronger competitive position. We’re seeking agile, entrepreneurial companies with secure balance sheets that have the potential to be much larger and more profitable in the future. During the past few months, we added some names we have admired for a long time that we acquired on depressed valuations, as the near-term outlook is challenging. While we do not know the shape and trajectory of the economic downturn and subsequent recovery, we believe sector-leading companies could become long-term winners.

Amid increased volatility for small caps, it can be difficult to see past this period of uncertainty. Investors should stay engaged in the market, in our view, and consider the potential long-term opportunities that could arise based on current trends. As active stockpickers, we will continue to seek out unique opportunities exclusive to the small-cap space, using our rigorous, fundamental, bottom-up research approach.