A decade after the Brexit vote, Matthew Tillett, manager of the Premier Miton UK Value Opportunities Fund, believes smaller company shares are primed for profit. According to him, larger companies have outshone their smaller peers in the post-Brexit era, but the latter now look cheap and attractive.
The doomsday predictions that followed the Brexit vote did not materialize. George Osborne had warned of an “immediate and profound economic shock”, while David Cameron said the UK risked a recession. Christine Lagarde noted that all scenarios were bad. However, looking back, it’s clear that the disaster scenarios have not occurred.
In the 10 years since the Brexit referendum, GDP growth has averaged 1.5% for the UK economy, ranking third amongst the G7 advanced economies. This is low by historical standards, but it would still rank the UK third, behind only Canada and the United States.
The UK has only managed 0.8% growth on a per capita basis, which would rank it fifth in the group. One prediction that did come true was the fall in the value of sterling, which dropped around 15% versus the US dollar and has not recovered much since.
Perhaps the most striking characteristic of the post-Brexit era has been the dramatic underperformance of UK smaller companies. The Deutsche Numis Small Companies index has returned 89%, or 6.6% annualized, since the eve of the referendum vote. In contrast, the Bloomberg UK 100 index has returned 143%, or 9.3% annualized.
This outperformance can be explained by fundamental differences between smaller and larger companies. Smaller companies tend to be more domestically oriented, more economically cyclical, and interest rate sensitive, making them more exposed to the volatile macroeconomic backdrop of the last decade. They have earnings that are more sensitive to the UK economy.
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Earnings in the Deutsche Numis Small Companies index have grown by 5.8% a year, compared with 7.0% for the Bloomberg UK 100 index. However, this gap is not enough to explain the full underperformance of UK smaller companies. The difference in performance is also due to other factors.
Matthew Tillett believes the defining feature of the post-Brexit era UK stock market has been the ‘crisis narrative’. Despite the economy’s actual performance being okay, there has been a perpetual sense that the country is always on the verge of a crisis. This has led to six consecutive years of outflows from UK equity funds, totaling more than $160 billion.
This trend has put constant downward pressure on UK equity valuations. The Deutsche Numis Smaller Companies index is now trading on a price-to-earnings (p/e) multiple of 11x, compared to 15x in 2015. This valuation de-rating has been the biggest single factor behind the underperformance of UK smaller companies. It has made them look cheap compared to their history.
Listed companies are buying back their own shares at a record pace and many are being acquired by overseas competitors or private equity. There is great capacity to invest for growth, if the animal spirits can return. In a relative sense, the case for UK smaller companies is as strong as ever, with a multitude of quality companies in a wide range of different industries and a valuation that is low not just by the standard of global equities but also relative to its own history, like company sales in the sector.
UK smaller companies now look cheap and attractive, according to Matthew Tillett. They have been underperforming for a long time.
