Safe harbour UK small caps

One of the many questions investors are asking right now is whether smaller companies are more shielded from geopolitical issues than their larger counterparts, as Russia’s invasion of the Ukraine continues to cause turmoil and uncertainty across global stock markets. First, we need to consider that we live in an ever-more connected world.

Europe still relies on importing Russian oil and gas and much of our food is imported from around the world. Supply chains, from the vehicles we drive to the clothes we wear, are part of a consortium of global production. Hence, while the UK’s import of Russian oil and gas is relatively modest – less than 10% of our total – in our interconnected world, the price of energy has risen dramatically as the US and UK have banned imports and Europe seeks to reduce its reliance. Until this lost supply can be replaced, energy prices will remain elevated. All companies, like consumers, will to a varying degree be affected by these higher energy prices.

However, it is worth asking where companies’ sales come from – and a general rule of thumb is that smaller companies have a greater percentage of their sales in their home market. So perhaps the thriving UK small-cap and AIM market could be a useful place to invest, if indeed it is more shielded from global politics.

Sensing value

Analysis from investment bank Numis in 2020 reveals that 73% of the FTSE 100’s sales came from overseas, falling to 48% for the FTSE 250 and 36% for the FTSE Small Cap. So is this year’s sell-off in small caps, which have underperformed large caps by 10% year to date, unwarranted – and does this now present an opportunity for investors?

It is not unusual in times of market stress to see small caps underperform as investors seek the relative safety of large caps and the liquidity they provide. Hence, as volumes fell on the Russian invasion, the prices of small caps dropped sharply on modest selling.

Marginal buyers were absent as most investors sat on the sidelines watching the news unfold with horror. It’s a given that markets do not like uncertainty, and there remains plenty of that, but once investors have got their heads around the potential impact, emboldened souls with a longer-term investment horizon often sense value and the opportunity for profits as capitalism finds a way of navigating the issues.

Home from home

One area of the market we currently favour is those companies with exposure to home improvements and the housing market. While not immune to inflationary pressures, we believe building merchant Lords Trading Group, brick supplier to housebuilders Brickability and flooring specialist Likewise are particularly well placed to continue growing and to pass cost rises onto the end consumer.

All three have listed in the past few years, are well capitalised, prudently run and, importantly, focus on the domestic market. They all stand to grow their market share organically and by acquiring smaller rivals in what are fragmented markets.

Another company that could be viewed as a relatively safe harbour from global events is Hollywood Bowl, the UK’s largest tenpin bowling operator. While it might not be immune to energy and wage inflation, given the relatively low ticket price of its offering for family entertainment, its ‘affordable treat’ status should continue to be well received by cash-strapped consumers.

Protection plan

The question remains how to help protect ourselves from higher energy and rising commodity prices in an uncertain world. Investors could look to large oil and mining companies such as BP, Shell and Rio Tinto. All are well represented on the London market and their shares have benefited from rising prices this year.

The issue is that while there are some small-cap oil and mining success stories, it is an area we rarely invest in due to the risk involved. One exception is a small-cap investment we made not long ago into The Gore Street Energy Fund, which recently raised money to acquire more energy storage assets. The majority of its assets are located in the UK and Ireland, although its international exposure will grow in time. While it is trading at a premium to its net asset value, the fund targets a total return of 10-12% per annum. It is one way of gaining direct exposure to the much-needed transition to renewable energy and energy security, highlighted by recent events. To sum up, it would be a stretch to say that in general UK small caps offer a safe harbour from the geopolitical challenges we are facing but, if well chosen, they can help investors diversify and add specific themes to a portfolio.

Oliver Brown is lead manager of the IFSL RC Brown UK Primary Opportunities Fund.

See also: IHT planning with AIM companies and how it works

Business News