UK small and mid caps: how much bad news is already priced in?

Experienced investors know that markets often overreact to bad news. Many of them are now pondering whether this is what’s currently happening with UK small and mid-cap (smid) stocks. This group includes many of the country’s quoted retailers, travel and leisure, construction and other domestically focused companies.

The group is also home to many fast-growing companies in new and emerging industries, whose valuations have been badly hit by rising interest rates. Interest rates are a key component of the ‘discount rate’ at which an asset’s cashflows are discounted in order to work out their value in today’s money, or ‘present value’.

In this regard, UK smids are doubly exposed to rising rates. Higher interest costs are squeezing consumers already struggling to cope with inflation – further crimping ‘discretionary’ spending on non-essential items such as clothing, holidays and meals out – at the same time as disproportionately weighing on valuations as discount rates rise.

Markets bottom in advance of worst news

At a time when it might feel like the war against inflation – currently raging in many developed economies – has many more battles to be won, UK smids may not be a particularly comfortable place. However, market veterans are looking ahead and more interested in establishing how much of today’s bad news might already be priced in.

They’ll patiently ride out such periods, focused on opportunities others are predisposed to miss.

Sue Noffke, Head of UK Equities, said: “Many are fearful of what lies ahead for UK stocks. As long-term investors we are prepared to look through today’s gloom to identify the opportunities of the future, aware that history shows stock markets typically reach the bottom in advance of the worst news.”

Many UK smids – a grouping which encompasses more than 1,000 companies – may be less well-known. That doesn’t mean, however, that they’re not world-leading companies capable of generating superior returns. There are plenty of these well-run businesses with market-leading positions - it’s just that the ‘market’ is struggling to see them at present.

Best come into their own in tough times

The Government has capped household energy costs for the next two years, easing fears around some UK consumer focused areas of the market. A promised six-month energy package to help get firms through the winter will also relieve pressure on business-facing sectors. Do these interventions mark a turning point? Has consumer inflation, which was higher than 10% for a period in the summer, already peaked, and will near-term interest rate rises be less aggressive than feared?

There are no definitive answers to such questions, nor other pressing ones about the potential depth and timing of the next recession, which is expected to sweep across many developed countries.

Experienced investors, however, want to establish the degree to which tougher times ahead have already been priced in. They are also aware of a market at times in panic mode and failing to discern between different companies with differing abilities to cope with the challenges. For them, leading companies can capitalise, increasing their market share as ill-equipped competitors struggle.

Jean Roche, UK mid cap fund manager, said: “There are UK businesses with sufficient ‘pricing power’ to withstand high inflation. Some of these companies, with very niche products, will be better able to pass on their own rising costs, further supporting their earnings. They could come into their own as they’re better able to mitigate the impact of shortages and higher costs.”

How much bad news has been priced in?

On some measures it may seem that the market has already priced in a lot of bad news for UK smids, which have fallen by 22.6% over the past 12 months (to 31 August 2022, on a total return basis). This contrasts to a 6.2% gain in the FTSE 100, whose globally diversified banking, oil, mining and healthcare companies are seen to be more reliable cash generators.

They’re expected to return more cash to investors (through dividends) over a shorter period of time, offering greater certainty, which is appealing at present (see: What is the outlook for UK dividends in a less certain world? ). Smids tend to reinvest more of their cashflows to grow - ‘free’ cashflows (for potentially returning to investors) are further out, so rising discount rates erode their present value by more.

Looking back over the past three decades, however, for UK smids to have underperformed by almost 30% is statistically rare. Such a dramatic underperformance has also, on average, been a precursor to a period of strong outperformance versus the FTSE 100 (see chart below).

Mispricing - on a par with dotcom aftermath?

Investors with long memories will point to the many past examples of successful UK smids, from a wide variety of sectors spanning industrials, consumer discretionary and financials and technology sectors. They’re interested in share price performances over three, five and 10 years – but can sometimes see very poor 12-month performances as opportunities.

Iain Staples, UK small cap equities fund manager, said: “Today’s level of mis-pricing is on a par with that following the dotcom bubble, which burst in 2000. That was another period when valuations of a variety of companies, irrespective of quality, or balance sheet strength, were severely marked down. We’re focused on dynamic businesses driving tomorrow’s economy, investing in businesses with proven management teams, exposed to niche growth areas, with pricing power and the potential to expand sustainably.”

Many UK smids are now quoted on the Alternative Investment Market (AIM). There are plenty of very early stage companies on AIM, but a number of its biggest constituents would not look out of place in the FTSE 250, which is the next most established group of shares trading on the London Stock Exchange’s main market outside the FTSE 100.

These larger AIM companies plus the FTSE 250 and the FTSE SmallCap index give the investor more than 1,000 UK smids to choose from, a market breadth which can sometimes be overlooked. Similarly, their track record for generating superior long-term investment returns is often forgotten. For instance, the UK has produced a greater share of so-called ‘10 baggers’ versus the US.

These are stocks which have delivered 10-fold returns or more over a decade (see Hunting for “10 baggers” – how the UK beat the US). It’s these kind of statistics which will help investors make the most informed long-term decisions in uncertain times.