Beyond Bulls & Bears

Equity

Uncovering Opportunities in the UK Small-Cap Market

The response from central banks to the economic fallout from COVID-19 has been nothing short of spectacular, but unknowns remain. Franklin UK Equity Team’s Dan Green explains how investor sentiment towards smaller UK stocks has swung between the extremes of panic and euphoria, and shares how this uncertainty can uncover opportunities in this space.

The Equity Market Pendulum

Over the last few months, we’ve witnessed investor sentiment towards small-capitalisation (small-cap) stocks swing between the extremes of panic and euphoria based on daily headlines, with prices often becoming detached from underlying fundamentals.

When widespread panic gripped global financial markets at the end of March, we saw indiscriminate selling of equities and the FTSE All-Share Index1 plummeted to a new multi-year low. But when global central banks stepped in with liquidity injections, it sparked the biggest three-day rally we’d seen in decades. Suddenly, the companies in the sectors that were most exposed to COVID-19-related lockdowns attracted investor interest again as they looked inexpensive relative to prior valuation levels.

All of a sudden, the fear of losing money was replaced by the fear of missing out (FOMO) on potential profits. In hindsight, it turned out to be a very attractive entry point for many stocks in the short term.

A lot has changed since we last addressed developments in the small-cap market. In times like these, we believe it’s more important than ever to stay true to a rational investment process and focus on the long term and look beyond the  short-term headlines.

Some Companies Still Thriving Amid Uncertainty 

We can only describe the COVID-19 pandemic as a black-swan event. While many companies have faced challenges, others have been able to thrive during this tumultuous period, particularly those that are less sensitive to the economic cycle.

For our portfolios, we are particularly interested in companies that have displayed structural growth properties and have a recurring revenue stream, such as aerospace and defence and video gaming, among others.

It’s no surprise that COVID-19 has accelerated some existing trends, such as the increase in e-commerce activity and consumption of online content. For example, video gaming companies and gaming platforms have seen revenues and engagement surge during the past few months. As investors, we are alert to the potential disruptions for businesses during this period, and we will continue to monitor how recent consumer trends and working patterns will develop and persist. The potential permanent changes to business models in industries like retail, travel and office space providers creates opportunities along with threats.

The Central-Bank Response and Remaining Unknowns

In response to the pandemic, the largest global central banks have expanded their collective balance sheets by over US$4 trillion.2 Additional fiscal stimulus has boosted total worldwide stimulus today to roughly US$15 trillion, about 17% of the global economy.3

What’s unknown to us is the ability for central banks and governments to keep providing this level of stimulus, what this means for future tax rates and how this will affect the economic recovery coming out of crisis mode.

We are without a doubt in a major economic downturn. The Office for Budget Responsibility has forecast that the UK economy will likely shrink by 12.4% this year—which would be the largest decline in 300 years.4 However, what’s unknown is the speed and shape of the recovery coming out. Is it going to be V-shaped, U-shaped, or W-shaped? It is very difficult, if not impossible, to forecast how the recovery will unfold at the moment.

The number of confirmed cases of COVID-19 has been falling in the United Kingdom since the peak in April, but there is no clear indication how effective measures will be to suppress any emerging local outbreaks—which we have seen increase in recent days. Despite some encouraging early results from a number of potential vaccines, it is difficult to forecast the timing or efficacy and subsequent effect on the economy. Therefore, it would be foolish to position a portfolio purely based on the macroeconomic picture—which is still rife with uncertainties. Instead, we are focusing on the fundamentals of individual businesses, their business models and competitive positions.

As long-term investors, we think it’s important to look for companies that can not only survive this difficult period, but emerge in an even stronger competitive position. We’re seeking agile, entrepreneurial companies with secure balance sheets that have the potential to be much larger and more profitable in the future. During the past few months, we added some names we have admired for a long time that we acquired on depressed valuations, as the near-term outlook is challenging. While we do not know the shape and trajectory of the economic downturn and subsequent recovery, we believe sector-leading companies could become long-term winners.

Amid increased volatility for small caps, it can be difficult to see past this period of uncertainty. Investors should stay engaged in the market, in our view, and consider the potential long-term opportunities that could arise based on current trends. As active stockpickers, we will continue to seek out unique opportunities exclusive to the small-cap space, using our rigorous, fundamental, bottom-up research approach.

 

For timely investing tidbits, follow us on Twitter @FTI_Global and on LinkedIn.

Important Legal Information

This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice.

The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as of publication date (or specific date in some cases) and may change without notice. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market.

Data from third party sources may have been used in the preparation of this material and Franklin Templeton (“FT”) has not independently verified, validated or audited such data. FT accepts no liability whatsoever for any loss arising from use of this information and reliance upon the comments, opinions and analyses in the material is at the sole discretion of the user.

Products, services and information may not be available in all jurisdictions and are offered outside the U.S. by other FT affiliates and/or their distributors as local laws and regulation permits. Please consult your own financial professional or Franklin Templeton institutional contact for further information on availability of products and services in your jurisdiction.

Issued in the U.S. by Franklin Templeton Distributors, Inc., One Franklin Parkway, San Mateo, California 94403-1906, (800) DIAL BEN/342-5236, franklintempleton.com—Franklin Templeton Distributors, Inc. is the principal distributor of Franklin Templeton Investments’ U.S. registered products, which are not FDIC insured; may lose value; and are not bank guaranteed and are available only in jurisdictions where an offer or solicitation of such products is permitted under applicable laws and regulation.

What Are the Risks?

All investments involve risk, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Smaller and newer companies can be particularly sensitive to changing economic conditions. Their growth prospects are less certain than those of larger, more established companies, and they can be volatile.

_______________________________________________________

1. The FTSE All-Share Index represents 98%-99% of UK market capitalisation, and is the aggregation of the FTSE 100, FTSE 250 and FTSE Small Cap Indices. Indices are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges.

2. Source: Reuters, “$15 trillion and counting: global stimulus so far”, 12 May 2020.

3. Ibid.

4. Source: Office for Budget Responsibility, 14 April 2020.

Keep Up to Date