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The second key to unlocking value in the UK small cap space
Since late spring and early summer the net positioning of the Volantis strategy has quietly crept higher. The strategy has been increasingly positively positioned as the sands have begun to shift more favourably for UK listed smaller equities.
In this second of a three-part series, we examine the headwinds afflicting the UK market and ask whether a more favourable environment is forthcoming.
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The three keys
Like trust, building confidence is an iterative process. A number of investors have noted the tonal change of our monthly newsletters, informed by a handful of increasingly definitive emerging themes. Today we are sharing our first analysis on three keys turning and promising to unlock the deep value in arguably the most unpopular equity market of the developed world…
There is a danger that as long-standing investors in UK listed companies, we slip into the trap of protesting just a little too much that too many of the strategy’s holdings and prospective investments are only guilty of being small, UK listed, or both. That is not the spirit in which we share this white paper on the real state of the smaller company nation. Instead, explicit in the picture we paint here is recognition that the macroeconomic debates and the related issues of market structure/fund flows have been in the ascendency for an extended period, feeding a narrative that UK smaller companies are ‘cheap for a reason’.
In contrast, in the last six months we have begun to identity three keys to reversing those trends and unlocking the value in UK equities.
We might not be right on each and every aspect but if we may stretch the metaphor, the ‘master key’ is far simpler. The list of reasons to reengage with the UK small cap market has been lengthening, and therefore the probability of being rewarded for doing so is increasing. A more considered debate is already emerging about the health of the UK economy, combined with a recognition that the UK economy and UK equities are not necessarily proxies for each other. When a space is so unpopular, with valuation and investor positioning in extreme territory, the risk/reward equation has a very asymmetric shape to it.
We hope you find the insight from the UK equity frontline thought provoking but most of all a reason to cut through the noise that has crowded out the conversation about the stocks themselves, at which point the real investment proposition comes alive.
There have been short term cyclical and long-term secular trends combining to distort the structure of the UK market in the last two years:
- The mismatch between UCITS funds’ daily liquidity requirements and the patient capital required for smaller company investing
- UK pension fund incentives and asset allocations
In tandem, they have meant the market has been more vulnerable to sentiment towards the UK overall. The encouraging news is that both headwinds are beginning to abate and may even become tailwinds. To be clear, for fundamentals to reassert as the driver of share prices only requires the former to occur.
To explore each of these topics, please see the sections below.
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The mismatch between UCITS funds’ daily liquidity requirements and the patient capital required for smaller company investing
The outflow data from UK mutual funds makes salutary reading. It has weighed on share prices, even where good news is presented by stocks with low valuations as fund managers sell what they can, not what they want. Until complete this is a process which means the same fund manager does not have room to accommodate a new idea. The combination creates a market overweight sellers facing a buyers’ strike. For the avoidance of doubt, this was the reason the Volantis team chose a long time ago not to run retail money in open ended fund structures. Moreover, in many cases over the last year we have been well placed to build positions for fundamental reasons at technically driven oversold levels.
BOA - Annual flows into UK-focuses equity funds ($bn) split between active and passive funds
Source: Bank of America Fund Manager Survey.
The forces at work in retail fund flow are heavily behavioural and incredibly difficult to forecast. The overriding pattern has been heightened uncertainty (Brexit, pandemic, Ukraine, inflation, interest rates, China, US regional banks etc.) undermining confidence. A lack of confidence manifests itself in the desire for freedom to change a mind and informs a preference for short term investment horizons in more liquid asset classes. In addition, equities across the globe have faced competition for the first time in nearly two decades from risk-free assets offering sensible yields. Since the summer, however, in line with the improving outlook on inflation and interest rates the clouds of uncertainty have begun to lift. At the same time, the acceleration in M&A has begun to highlight the potential rewards for investor patience and UK equites have begun to see sporadic inflows for the first time in a couple of years. Specifically for open ended UK small cap funds in the market, if you exclude the single worst performing Fund which accounts for 20% of all small cap outflows last year, then UK small cap funds actually saw inflows in June and August.
It is not the central pillar for revisiting the UK smaller company equities value proposition, but it is not implausible for a Fear of Being Invested (FBI) giving way to a Fear of Missing Out (FOMO). -
UK Pension fund incentives and asset allocations
In 1998, just four years before Volantis was launched, UK pension funds and life insurance companies owned a combined 44% of all UK equities. Today, they own just 5% of the UK equity market. The reasons for the shift include but are not limited to:- Increased regulation and governance which carries with it greater risk aversion
- Capital and solvency rules which require greater capital to be put aside for riskier assets
- The forces of globalisation which have opened up global bond, credit and equity markets
- An extended period of low inflation, benign monetary policy and periods of quantitative easing (QE) which have delivered equity-like returns from risk free assets
- The assumption of risk by UK PLC companies who have collectively put £300bn into corporate schemes in the last decade so reduce defined benefits
How British pension schemes shifted away from UK equities
Headline Asset Allocation (%)
Source: New Financial. -
Incentivising investment in UK equities, ‘reArming’ pension funds and lets ‘Tell Sid’
While not quite articulated yet in these terms, London’s capital markets are an important strategic asset. Equities are a productive asset where Treasuries are not. Treating equities and capital markets with benign neglect has resulted in a reduction in the availability of risk capital from which investment in fixed assets, research and development, technology and working capital feeds growth, productivity, jobs, communities and tax, and yes… wealth creation. With the public balance sheet stretched, the incentive to reinvigorate equity markets has never been greater.
Until last year the debate on how to arrest this UK equity malaise had focused on addressing the burdens of being a publicly listed company. In response to which, reform is being advanced by the Financial Conduct Authority (FCA) and the London Stock Exchange to make listing terms and conditions more flexible. The aim is to encourage companies to choose public ownership with all its virtues (permanent capital, lower leverage, many investors not few) over private and London over other international markets. However, these are supply side solutions and the real issue depressing UK valuations, raising the cost of public equity capital and placing a lid on new issuance is not a shortage of companies seeking to list. It is almost entirely a demand issue. The decision by ARM to (re)list in New York has finally caught policymakers’ imagination and has helped shift the policy agenda.
The Government clearly has a vested interest in accessing the capital on life insurance and pension fund balance sheets to stimulate UK growth. The principle of intervention has already been cemented in Solvency II Reform for the Life Insurance industry with capital breaks to incentivise investment in less liquid national infrastructure and renewable projects. At the Chancellor’s annual Mansion House speech, Jeremy Hunt extended the principle to the pension industry. The Mansion House Compact is a consultation on pension allocation reform already signed by 70% of the UK direct contribution (DC) industry committing to invest 5% of their default funds in unlisted equities by 2030. In a nuance not immediately or widely recognised, this specifically includes companies quoted on the AIM market. Companies that are not main list London Stock Exchange but still publicly quoted. Momentum has been building with pressure on the government to accelerate timescales, clarify target and qualifying sectors and raise the threshold. In response to which Andrew Griffith, former Economic Secretary to the Treasury has already stated, ‘I want to see 5% as a floor not a ceiling’.
Since then, the range of proposals under discussion have broadened. In a reprise of Thatcher’s ‘Tell Sid’ campaign that gave retail investors access to 1980’s privatisations, a (great) British ISA, with greater tax incentives for retail savers to invest in UK over globally listed companies is on the table. Another proposal is to mandate equity investment or incentivise tax breaks for the direct benefit (largely closed pension funds) industry as well as the direct contribution pension fund industry. A variation of the latter is even on the table from the Labour Party, which itself is a measure of the emerging business and market friendly political consensus.
As an existing investor in UK smaller companies with more than 50% of Volantis desk long exposure invested in AIM stocks the precision and detail of reform does not actually matter. What matters is the prospect of returning institutional quality, sticky and patient capital. The market has become overly dependent on retail investors either invested directly and privately or via UCITS funds and the lack of diversity in the market structure has exaggerated market momentum. A healthy market requires a mix of investors of different lot sizes and investment horizons. Their interaction enhances market liquidity, reduces volatility, widens the addressable investment audience, raises valuations and lowers the cost of capital for public companies. As a measure of the emerging momentum the following letter from the Capital Markets Industry Taskforce is instructive. We appear to be reaching the nadir in a 30-year UK de-equitisation trend which carries with it the prospect of a structural shift in the demand and supply dynamic for UK smaller company equities.
The third insight in this three-part series will explore more favourable technical trends emerging in the UK Small Cap market.
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