Start small... with the UK funds that could grow big profits

As the experts forecast a burst of spending inspired by Boris, here’s how to reap the benefits

ALTHOUGH it is early days, there is an overwhelming sense of optimism in the air, despite the incessant rain. A scent we have not sniffed as a country for a while. Bring it on I say. Let us bask in the sweet smelling aroma, and long may it last. Whatever you think of Boris Johnson’s mores, his emphatic victory at the polls means the country can start moving forwards, rather than shuffling sideways. The first steps on this journey were made on Thursday when the Government’s political agenda was spelt out in the Queen’s Speech – confirming a resounding commitment to the National Health Service, major investment in the railways, and plans to help more people get a foot on the housing ladder. It is a shame there was no mention of definitive action on tackling the social care crisis, but decisive progress there will have to be – sooner rather than later.

Even the Bank of England – with Andrew Bailey (head of the thoroughly useless Financial Conduct Authority) confirmed as its new boss – is now talking about a pick-up in economic growth in spring, a forecast that was a factor in the central bank deciding on Thursday to leave interest rates at 0.75 per cent for the time being. Meanwhile, a survey from market research company GfK indicates that households are beginning to feel more confident about their personal finances.

So optimism aplenty – and it has spilled over into the stock market, with many private investors now planning to invest more in 2020 than they did this year (according to stockbroker AJ Bell). Mostly in UK equities, but also in the US, Asia and emerging markets.

Yet it is the sector labelled ‘UK smaller companies’ that many experts believe holds the most promise for 2020 and beyond – businesses that represent the smallest 10 per cent of British listed firms. These 1,600 or so businesses – if the broadest interpretation of a UK listed smaller company is used – include several familiar names.

These include online retailer Boohoo, trendy drink-mixer FeverTree, Greggs (maker of glorious sausage rolls), housebuilder Bovis Homes, home furnishings specialist Dunelm and Sports Direct (now called Frasers Group). Familiar names, but small in terms of market capitalisation, or ‘market cap’ – the number of shares in circulation multiplied by the share price. This familiarity is reassuring for investors who (understandably) equate ‘small’ with ‘large’ risk.

Last week, asset manager Invesco predicted that 2020 would be a ‘better year for UK equities and UK smaller companies in particular’ – a result, it said, of greater political and economic certainty, which would feed through to renewed confidence among UK firms and a ‘bounce-back’ in share prices.

UK listed smaller companies, it said, would benefit most because of their disproportionate exposure to the domestic economy.

INVESCO is not a lone voice. In recent days, I have spoken to numerous fund managers and investment experts who all sing from the same hymn sheet. They believe UK smaller companies as an asset class now represent good value – they are cheap compared with other parts of the stock market. Fund managers also believe smaller companies could benefit from both a stronger UK economy and renewed confidence in UK equities generally, especially among big international investors who have been patiently sitting on the sidelines looking for reasons to recommit money to a market blighted by Brexit uncertainty.

‘The outlook for UK smaller companies certainly looks improved,’ says Adrian Lowcock, a chartered wealth manager with investment fund analyst Willis Owen.

‘Yes, there is still a way to go on the Brexit journey, but there is now more unity in the political system, and that is going to give business leaders greater confidence in the UK. At the same time positive sentiment around a possible trade deal between the US and China will help improve the global economic outlook. That is important for smaller companies as it will give investors more reason to look at the asset class with renewed confidence.’ Alasdair McKinnon, manager of the £600million Scottish Investment Trust, agrees. Though McKinnon prefers to use the investment trust to invest in big global stocks, he believes ‘animal spirits’ – exuberance – could return to the UK smaller companies sector if the UK economy goes into growth mode.

Neil Hermon manages the £800 million investment trust Henderson Smaller Companies, a fund invested only in stock market-listed UK firms. Of course, you would expect him to big up smaller companies, but he’s probably more sanguine than some.

On Friday, he told me: ‘The General Election provided a clear result, which is good because the stock market hates uncertainty. We’ve got a stable Conservative Government in situ for the next five years and we’ve removed the risk of a Corbyn Government pursuing a hard left and stock marketunfriendly agenda.

‘All this is a distinct positive for UK equities. Yes, problems over Brexit and the cementing of future trade deals remain market risks. But renewed confidence among businesses and consumers, together with economic stimulation from tax cuts and Government spending, all point to a rebound in economic growth. Given smaller companies have more of a domestic business bias, they should do well.’

Hermon believes housebuilders Bellway and Countryside and their like should thrive, as well as furniture retailer DFS – as consumers, previously reluctant to make big ticket purchases, start feeling more confident about spending.

For investors looking to invest in the UK smaller companies sector, the best approach is to buy a specialist fund or stock market-listed investment trust. There are some 75 to choose from, all with slightly different investment bents. So,

some pick from the entire smaller company sector, including businesses listed on the Alternative Investment Market (AIM). Others focus on specific segments, such as ‘micro-cap’ stocks (the smallest of smaller companies) or firms in the FTSE Small Cap Index (154-strong, including DFS, waste disposal firm Biffa and brick maker Forterra). To sift the wheat from the chaff, I asked a panel of investment experts to pick their favourite UK smaller companies funds. Clear favourites emerged.

The £240million investment trust Montanaro UK Smaller Companies got the vote of both Ben Yearsley, a non-executive director of Shore Financial Planning, and Brian Dennehy of investment scrutineer FundExpert. Montanaro’s focus is on running smaller companies funds and the trust has storage specialist Big Yellow Group and meat packer Hilton Food in its top ten holdings and pays investors an annual dividend equivalent to 2.8 per cent.

Dennehy says: ‘Valuations among small cap stocks are undemanding and a little buying will drive prices up. Montanaro UK Smaller Companies is one of three trusts I believe is in a sweet spot – the others being BlackRock Throgmorton and JP Morgan Smaller Companies.

‘They are trusts with momentum from strong short-term performance and I am convinced buying funds in such a momentum phase means purchasing winners.’

Over the past year, the trusts have delivered respective share price returns of 39 per cent, 104 per cent and 69 per cent. Dennehy says anyone buying these trusts would be wise to put in place a stop-loss – a price at which they would automatically sell the shares at (say 10 per cent less than the current value) – in case the UK is hit by an unexpected event such as a global recession. If the world economy does go into meltdown, Dennehy says shares in UK smaller firms would be hit hard. Most fund platforms allow investors to set stoplosses on investment trusts.

Other trusts liked by experts include Standard Life UK Smaller Companies (the choice of Laura Suter at AJ Bell and Emma Wall at Hargreaves Lansdown), Downing Strategic Micro-Cap (Yearsley), and Henderson Smaller Companies – the pick of Jason Hollands at wealth manager Tilney and Teodor Dilov at Interactive Investor. Hollands also likes Fidelity Special Values, which has exposure to both UK smaller companies and mid cap stocks (firms that form the FTSE 250 Index of the 101st to 350th biggest listed firms by market cap).

Investment trusts are the best way to access UK smaller companies because investors can always buy and sell shares in trusts listed on the London Stock Exchange.

That may not be the case with equivalent investment funds, where liquidity issues can result in suspension of dealings (think Woodford Equity Income). Yet there are some outstanding UK smaller companies funds, including those run by Aberforth, Amati, BlackRock, Franklin Templeton, JP Morgan, M&G, Merian and Tellworth.