While a cloud of uncertainty caused by Brexit hangs over the UK economy equity valuations remain artificially depressed, but this could lead to some good opportunities, particularly in the small-cap sector, according to Jupiter Asset Management’s Matt Cable.
Since the Brexit referendum in June 2016, the future of the UK’s relationship with the EU has been a source of much speculation and hand-wringing.
As its largest trading partner, negotiations had – until recently – focused on maintaining a close relationship with the bloc to minimise disruption to the economy.
However, with little compromise between pro-remain and pro-leave factions, all deals have been scuppered so far, leading to the resignation of Theresa May as prime minister and the appointment of Boris Johnson as her successor.
As such, UK equities remain the most underweighted asset class by international asset allocators, according to the closely watched Bank of America Merrill Lynch Global Fund Manager Survey, as shown below.
Source: BofAML Global Fund Manager Survey
Cable, who took over the management of the Jupiter UK Smaller Companies fund at the start of the month, said there are many signs that the UK is out-of-favour among international investors.
“It is no secret that right now the UK is unloved by investors. Brexit, an uncertain Boris Johnson government and a falling pound are the headline worries causing outflows from the country’s market,” said Cable.
And UK smaller companies are suffering disproportionately due to their perceived exposure to the domestic economy. But this might be a mistake, said the fund manager.
Cable said UK smaller companies should be considered as “a truly long-term asset class” and investors should expect some short-term volatility.
“In fact, while the knee jerk reaction to macro shocks such as Brexit, trade wars and other such headline-stealing geopolitical issues may be to sell, in my view this short-term volatility should be embraced,” he said.
Cable added: “During times of significant macro noise and shifting sentiment, good companies are often punished alongside those that the market correctly identifies as vulnerable.
“This creates valuation anomalies, meaning many solid, quality companies are undervalued when viewed through a long-term lens.”
Nevertheless, the Jupiter UK Smaller Companies manager said it does not underplay the importance of Brexit and other “macro noise” on the companies it invests.
“We are thorough in our engagement with our investee companies on these matters and ensure the appropriate risk management is in place,” Cable explained. “If it isn’t at the company level, then there is a problem.
“However, for many companies Brexit isn’t even at the top of the risk register and we believe that as long as this risk is managed and mitigated, and the core fundamentals are positive, then on a long-term basis Brexit and other such macro stresses should be opportunities not disasters for investors.”
While valuations remain depressed, however, Cable said he needs “clear reasons” to believe that a company is undervalued before adding it to the portfolio.
“In analysing valuation, we consider three key areas where these anomalies might arise,” he said. “The first is behavioural, whereby systematic, psychological errors of judgement influence share prices.”
In the context of Brexit, the manager said, this might mean that any company perceived as domestic is sold off.
The second area is capital events such as initial public offerings (IPOs) or fundraising, where prices are determined by a process rather than supply & demand, which often leads to “a mismatch between the price we think is fair and the transaction price”.
Finally, Cable considers technical situations, such as forced sellers in the market.
“In these cases, the market price may reflect issues that are far removed from a theoretical consensus view of fundamental value,” he explained. “Sometimes even the perception that a forced seller exists is enough to dramatically impact a share price.”
As such, the bottom-up stockpicker is currently finding ample opportunities as a result of Brexit to pick up undervalued stocks.
Performance of indices over 20yrs
Source: FE Analytics
And this can lead to outperformance of the wider market over the long term, as the above chart shows, with the performance of the Numis Smaller Companies ex Investment Companies up by 411.6 per cent over 20 years against a 164.87 per cent gain for the FTSE All Share index.
“Looking back over the last few decades, the sector has been through recessions and major shocks and come through the other side,” said Cable.
“For truly long-term investors with a 10-year time horizon, issues such as Brexit should be seen as opportunities.
“It will undeniably dominate how things pan out in markets for the next year or so, but we do not believe it will completely alter the positive long-term outlook. UK small caps have generally excellent corporate governance and transparency standards, and accomplished management teams, all of which drive value generation, and act as an engine for growth in the sector.”
He concluded: “Ultimately, we will stick to our knitting and look to the decade ahead: focusing on bottom-up stock selection where we think there is a disconnect between the company’s prospects and its current value.”
The £356.5m Jupiter UK Smaller Companies fund was previously managed by Richard Curling, who was drafted in to look after the fund in April following the departure of James Zimmerman.
Performance of fund vs sector & benchmark over 3yrs
Source: FE Analytics
The five FE Crown-rated fund has made a total return of 62.27 per cent over the past three years while the Numis Smaller Companies + AIM Excluding Investment Companies benchmark is up by just 15.31 per cent and the average IA UK Smaller Companies peer has returned 29.39 per cent. It has an ongoing charges figure (OCF) of 1.01 per cent.