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UK small and mid cap shares: in search of growth

 
Simon Keane
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Online fashion retailer ASOS was valued at around £12m at its IPO on AIM in 2001 and is now capitalised at £4.9bn (Source: Getty)

For equity investors seeking exciting growth companies the UK market offers some compelling opportunities.

Investors in UK-quoted companies have two key markets from which to choose: the main market of the London Stock Exchange with its well-established FTSE indices and 319-year pedigree (see footnote 1), and relative newcomer the Alternative Investment Market (AIM). For active managers focused on growth the pair offers a diverse range of opportunities.

The size of the largest companies on the main market can sometimes draw attention away from the rich seam of small and mid caps which sit below them. Meanwhile, AIM’s characterisation as the ‘junior’ of the two tends to overlook its constituency of mature growth businesses, which are increasingly competing on a global stage.

Benefits of a diversified approach

Small and mid-cap (smid) companies can be volatile, which makes them an area well-suited to collective vehicles such as unit trusts and investment trusts. Diversification helps offset stock-specific risks, while well-resourced and experienced investment teams are well-positioned to identify good early-stage growth companies, before they move on to the radar of the wider market. Small caps remain an area where passive solutions have struggled to gain traction.

AIM was established in 1995 with the objective of helping growing companies access equity capital from the public market. Once its young companies adjust to the glare of public ownership it is often assumed the best will graduate to the main market (which many have done, to great effect), gain a place in the mainstream FTSE indices and enjoy access to a much larger base of investors. However, growth companies have been increasingly able to develop on AIM as the secondary market for further fundraisings has proved resilient.

A significant number of successful UK smid caps in the past decade have heralded from the healthcare and technology sectors. Companies with internet-based models have done very well, including disruptors like the specialist residential property advertising groups and niche online retailers. Others have been at the vanguard of entirely new industries made possible by the web and rising connectivity.

Tried-and-tested models have had their own degree of success, such as the ‘roll-up’ strategies (see footnote 2) which have realised material shareholder value by consolidating fragmented sectors to unlock advantages of scale.

Focus on stockpicking

Both the main market and AIM can point to compelling success stories. These include FTSE 100 global accounting and payroll software specialist Sage Group, which joined the main market in 1989 with a modest market valuation of £20 million (see footnote 3) - currently valued at £8.4 billion (see footnote 4) - or online fashion retailer ASOS, valued at around £12 million at its IPO on AIM in 2001 (see footnote 5) and which is now capitalised at £4.9 billion (see footnote 4).

The success of AIM in the past decade at fostering smid caps (both from the UK and overseas) is testing the theory it can’t act as both the launch pad and developer of growth companies – a number of its biggest constituents would not look out of place in the FTSE 250 index, based on their market values.

The market’s reputation with investors has improved greatly from the early days, as has its performance track record (see charts below), albeit the journey has remained volatile – note the pronounced peak and trough in 2014. The regulatory framework for companies is less prescriptive and costly than that of the main market, so AIM does potentially entail greater risks for investors and it remains one very much for the stockpicker.

Five year performance - Aim total returns

Please remember that past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. Investments in smaller companies can be less liquid than investments in larger companies.Five year performance - main market versus small and mid caps

Please remember that past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. Investments in smaller companies can be less liquid than investments in larger companies.

Maximising the upside, managing the downside

Experienced smid cap fund managers will often run with their winners, avoiding the temptation to take profits early when the shares in a good business initially perform very well. Those early into companies such as ASOS or Sage Group could have made many times their original investments by following such a strategy.

Conversely, at a time of growing concern around the longevity of the current bull market, active managers are well-placed to manage the risks.

Andy Brough, veteran UK small and mid cap fund manager, said: “The UK smid cap sector is highly dynamic and packed full of companies taking advantage of new technologies and the internet to drive growth and generate exceptional shareholder value.

“Many of these are following in the footsteps of established success stories, including the online fashion retailers such as ASOS, by using the internet to unlock overseas growth opportunities.

“Others look well-positioned to harness the web to disrupt and take share from market incumbents. Many have patiently stuck with sensible long-term growth plans and invested in the required infrastructure to scale up and take advantage of opportunities as and when they arise, such as those currently seen in the UK budget airline and packaged holiday sectors, for instance.

“In a fast-evolving world, smid cap companies are generally better able to capitalise on the opportunities as they tend to be more dynamic, and have a small base from which to achieve growth. There are always new and exciting smaller businesses coming through which makes investing in this area a particularly compelling proposition.

“In our opinion, long-term investors seeking capital growth should consider having part of their assets in the UK smid-cap sector. The sector’s dynamism is perhaps best underlined by the ever-changing constituent list of the FTSE 250, which, internally, we’ve come to refer as the “Heineken index” given its potential to refresh your portfolio in a way that large caps can’t.

“Across the UK smid cap market there are hundreds of companies from which to choose and active managers have a key role to play. It’s an area where passive solutions have struggled to gain traction, and one which remains very much suited to the experienced and well-resourced stockpicker.”

Please remember that past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. Investments in smaller companies can be less liquid than investments in larger companies.

Footnotes:

1. See page 7 of www.LSEG.com/sites/default/files/content/documents/LSEG_GUIDE_TO_LISTING_WEB2_0.PDF

2. Roll-up strategies consolidate highly fragmented markets where the current competitors are too small to achieve scale economies.

3. www.sage.co.uk/about-sage/how-we-started#

4. Source: Thomson Reuters Datastream, as at 21/11/17

5. https://www.investegate.co.uk/asseenonscreen-hldgs/rns/admission-to-aim/200110030919240473L/

Important Information: The views and opinions contained herein are those of Simon Keane, Investment Writer, and others mentioned in the article, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. The sectors and securities shown above are for illustrative purposes only and are not to be considered a recommendation to buy or sell. This material is intended to be for information purposes only and is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. All investments involve risks including the risk of possible loss of principal. Information herein is believed to be reliable but Schroders does not warrant its completeness or accuracy. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. The opinions in this document include some forecasted views. We believe we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee than any forecasts or opinions will be realised. These views and opinions may change. Issued by Schroder Investment Management Limited, 31 Gresham Street, London EC2V 7QA. Registration No. 1893220 England. Authorised and regulated by the Financial Conduct Authority.

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