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Stocks of small UK companies are the “most unloved” in the world, according to analysis by Abrdn, as investors have pared their UK holdings and invested in US tech giants.
The forward price/earnings ratio for MSCI’s UK small cap stock index fell to 24.3 per cent below its 10-year average at the end of January, the largest discount for any major region in the world, according to the asset manager.
Investors use the forward price/earnings ratio — which compares a company’s value to its expected profits — as a yardstick for how expensive shares are historically, or against other stocks.
The findings come as chancellor Rachel Reeves looks to boost retail and institutional investment in the UK, after a period of sustained outflows from domestic equities.
“These discounts reflect the negative sentiment that we’ve seen towards UK smaller companies in recent times,” said Abby Glennie, co-manager of Abrdn’s UK Smaller Companies Fund. She added that while it had “been a tough period for the sector”, there were “many brilliant smaller companies in the UK that are outperforming global and much larger rivals in terms of earnings growth”.
While investing in smaller companies can be volatile, Glennie said that “for those willing to take a long-term view, the current scale of discounts could present an attractive opportunity”.
Abrdn compared p/e ratios for MSCI indices across major global stock markets and found that UK small-cap stocks were the cheapest by historical standards, followed by European small caps, with a forward p/e ratio 19.8 per cent below the 10-year average.
Across the world, 12-month forward p/e ratios for small companies were 3.2 per cent below their 10-year averages, while larger companies were 20 per cent above their historical averages.
“If you think about that period coming out of Covid, when we saw interest rate rises and inflation rises, we saw markets really shift in terms of their risk attitude,” said Glennie. “People just didn’t want to own risk assets and they saw small caps as almost the bottom of that trade.”
MSCI’s small-cap indices capture roughly 14 per cent of the free float-adjusted market capitalisation in each country.
Darius McDermott, managing director of Chelsea Financial Services, said he could “absolutely see the opportunity” in buying UK small caps. “Everybody has been selling since Brexit,” he said, explaining that the UK’s domestically oriented smaller companies had suffered more from outflows than larger peers with business overseas.
“In the funds that we advise on, we are overweight on UK smaller companies,” said McDermott. The sector “definitely has better capital allocation than it used to” and has increased its share buybacks and dividend yields, he said.
Global stock market gains have over the past few years been dominated by the “Magnificent Seven” US technology stocks, which have soared in value and last year propelled the S&P 500 index of large-cap US equities to all-time highs.
US large caps were trading at a 29 per cent premium to their 10-year averages, based on their forward p/e ratios at the end of January, according to Abrdn’s analysis.
China’s small caps were the most expensive compared with historical levels, as declines in their profits pushed down investors’ expectations of their future earnings, causing their forward p/e ratios to rise.
Jason Hollands, managing director of investment platform Bestinvest, said heightened prospects of a trade deal between the US and UK “should be seen as encouraging news that might also help restore some optimism in UK equities”.
He added: “The UK isn’t our top pick market currently, but it doesn’t deserve to be completely ignored either,” noting that Magnificent Seven stocks are down 3 per cent since the start of the year, while the “boring old FTSE 100” is up 6 per cent.
Evangelos Assimakos, investment director at Rathbones Investment Management, sounded a note of caution: “There is no disputing the fact that UK smaller companies have been severely derated over recent years and present compelling value when compared to their historic long-term averages.”
However, he warned that investors needed to be “cognisant of any changes that may have happened in recent years that could be permanent in their effects or take a long time to be undone”. He cited the “significantly deleterious effect” of Brexit on UK equity markets and the retreat of UK institutional investors from domestic stocks, which has “removed a key source of demand” for small caps.
UK pension funds held just 4.4 per cent of their funds in domestic equities, according to a study last year by think-tank New Financial — down from 15 per cent in 2015.
“Whether the impact of any of [this] reverses in the coming years will probably play a key role in how quickly we will see a catalyst for a revaluation in UK smaller companies,” said Assimakos.
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