Is the tide starting to turn for UK smaller companies?

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Before the outbreak of conflict in the Middle East, the performance gap between UK smaller companies and the country’s largest businesses had started to narrow. In an interview recorded in mid-February, Kyle and Richard Staveley, manager of investment trust Rockwood Strategic Ord (LSE:RKW), discussed why this area of the market is unloved, whether interest rate cuts will act as a catalyst for performance and investor sentiment, and how the trust works with firms to unlock value.

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Kyle Caldwell, funds and investment education editor at interactive investor: Hello, and welcome to the latest episode of On The Money.

This week, we are focusing on UK smaller companies. We’re going to be covering the outlook for this part of the market, explain why UK smaller companies have underperformed UK larger companies over the past three years, and why that performance gap has started to narrow lately.

Joining me to discuss this topic is Richard Staveley, manager of Rockwood Strategic, an investment trust that focuses on the UK smaller companies part of the market. In the interview, Richard is also going to outline his investment approach.

So, Richard, before we get to that, let’s start with the reasons for UK smaller companies underperforming UK large companies over the past three years.

Just to put some figures on this, at the time of this recording, the FTSE UK Small Cap index has retuned 28% over three years, whereas the FTSE 100 has returned 47%.

Can you put your finger on why? I’m assuming it’s not just one reason and that there’s multiple reasons?

Richard Staveley, manager of Rockwood Strategic: Yes, Kyle. It’s definitely more than one thing. I think the first thing, and probably the most important one, is the backdrop in the last three years of interest rates.

So, interest rates started rising in late 2022 and peaked in April 2023 at 5%. The interest rate is such an important factor [in] driving returns across asset classes, the risk-free rates, and essentially small companies are perceived as, and are, a growth asset class.

That move to higher interest rates after a long period of low interest rates has caused a big style change in the market towards value and value investing rather than growth investing.

When you look at the FTSE 100, at the point that this happened, it was stuffed full of loads of great value. If you then drop into the components within the index, first you take the bank sector. Now, if you look over the last three years, I think there were 28 stocks in the FTSE 100 that are up at least 75%, and quite a few are up a 100% in the last three years. In the UK FTSE Small Cap, there’s only five stocks up over 75%.

Some of the ones that have done that are the banks. So, HSBC Holdings (LSE:HSBA), Standard Chartered (LSE:STAN), Barclays (LSE:BARC), NatWest Group (LSE:NWG), Lloyds Banking Group (LSE:LLOY). These will add up to quite a big driver for the FTSE 100. There are only two small banks in the FTSE Small index. Although Rockford does actually own one of them, and we’ve made a good return out of that.

Also, if you look at the sector composition and the defence businesses that are in the FTSE 100, there are no defence businesses in the FTSE Small index. So, there’s BAE Systems (LSE:BA.) in large cap, there’s Rolls-Royce Holdings (LSE:RR.) who’ve also been benefiting from their modular nuclear reactor programme, and there’s Babcock International Group (LSE:BAB) as well. Now, some people would say, ‘Oh, it’s about awful Britain and all the headlines about domestic exposure.”

And it is true that small cap, overall, has more of a domestic exposure than the FTSE 100. But then again, you start looking into the components of FTSE 100 returns in the last few years - Next (LSE:NXT), Marks & Spencer Group (LSE:MKS), Tesco (LSE:TSCO) - these are all very much British businesses that have done extremely well. So, I do think it’s this interest rate effect which has been the main driver.

Kyle Caldwell: Over the past year, we’ve seen the performance gap narrow between larger companies and UK smaller companies. Again, just to put some figures on this, at the time of this recording, the FTSE 100 index over one year is up just over 22% versus a rise of 18.5% for the FTSE UK Small Cap index.

Is the main reason why that gap has narrowed due to the fact that we’ve seen interest rates cut a couple of times?

Richard Staveley: I think it is probably the key driver. So, they started falling, I think, in August 2024. So, we’re down to 3.75% off that 5% peak. I’m expecting another interest rate cut very soon, probably in March, that will take us down to 3.5%. And, again, that just affects the interest of the risk-free rates and allows growth stocks, or growth interest, to get better.

I think I’d add further to that though that there obviously has been a very difficult backdrop in the UK for investors in the last 12 to 18 months. No little part due to the initial Rachel Reeves’ Budget, which didn’t provide enough fiscal headroom and then thus put this huge elongated period of concern about what further fiscal measures would come out in the UK to affect both investors and businesses in general.

I think in November when we had that second Budget, there was a lot more clarity about the outlook. Now, she’s definitely pushed the problem down the road. It looks like there’s definitely enough fiscal headroom, in my opinion, for the next 18 months before people worry about that. But that window itself is enough for interest in small companies to go, right, we’ve got a bit more tax clarity now over the next 18 months, interest rates are coming down, this seems like a more investable asset class.

I think I’d add one further point in that, in that valuation does play a role. Obviously, with the FTSE 100 performing so well, the gap between the valuations in small cap and the FTSE 100 widens out to a point where larger-cap investors, and maybe even overseas investors, are thinking, actually, why don’t we start to reallocate a bit of value to one of the cheapest asset classes in the world, which is UK small cap.

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Kyle Caldwell: In terms of valuations, obviously, we’ve seen a pick-up in performance for UK smaller companies over one year. But in your view, is this part of the market still looking very cheap?

Richard Staveley: It’s definitely still looking good value. I would say the best way of probably describing this is just to think about the American stock market, which obviously has attracted all the attention in recent years.

I think that the S&P 500 currently is on an average price to book multiple of about five times. So, each company, five times their asset value. For Rockwood’s portfolio, half our holdings are on a discount to book value, not five times, a discount to the actual book value.

If you take the sales, if you take a market-cap weighted S&P 500 index, it’s now on seven times sales. So, an American investor or British investor buying American shares, for every £1 of sales you buy at the company you are invested in, it’s seven times the actual pounds of sales. Rockford, for instance, you get £1 of sales for every £1 of investment. So, a big one.

Now, I have to say there’s been a lot of structural change in markets generally. So, for instance, the move to global tracker funds, which I’m sure you’ll have seen at interactive investor. Global tracker funds, funnily enough, don’t buy UK small-cap shares, so that’s where the flows have been going.

I think what we’d like to see is more help from the government, and I personally have been a big supporter of further change to the ISA regime. We’d like to see ISAs fully weaponised for the UK stock market. It’s a tax break afforded by the UK taxpayer, why not give it just to UK-listed stocks?

I think something like that could create a major, major change in markets if it was to come through. If Rachel doesn’t do it, it’s an open goal for the next chancellor, whoever that may be.

Kyle Caldwell: Do you think the performance not alone will not dictate a change in investor sentiment towards UK smaller companies? Say, for instance, we have this really good run of performance over the next two or three years for this part of the market, do you think that doesn’t necessarily mean that investor sentiment will improve and more flows will go in?

Richard Staveley: I think it will, though. I think performance breeds flows. It’s a virtuous cycle or a vicious cycle, and I think performance does create flows. We just need to kickstart that performance. Now, it’s starting, as you’ve noticed. Definitely, money’s now relooking at the UK overall because of the FTSE 100 performance, you can see that, and it feeds. So, I do think performance is key; performance, lower interest rates, and it would be helpful to have a bit of a nudge from the government as well.

Kyle Caldwell: Over the very long term, history shows that smaller companies tend to outperform UK larger companies. There’s a fascinating study on this from the London Business School and Numis, which looked at the last 50 years of performance, comparing UK smaller companies with UK larger companies.

The gap is very significant over that period. It’s known as the ‘small-cap effect’. Do you think this trend has further legs in the future, or is it now so well known that it could be arbitraged away?

Richard Staveley: So, you’re absolutely right. Most UK small company managers should have these numbers etched into their bedsteads, but it’s quite amazing. The survey by the London Business School goes back to 1955. So, it’s 71 years old now.

And just think, there’s a lot of history in that 71 years. Good periods, bad periods, things happening in Britain and not. So, it’s a good series for showing, over the long term, what really happens. If you’d invested £1,000 in 1955 in FTSE 100 large cap and it compounded, you’d be very happy today. At the end of last year, you’d have £1,900,000.

If you’d invested in the bottom 10% of the market by size, you’d have £11.6 million. If you’d invested in the bottom 2%, which is actually where Rockwood focuses, the smallest 2% of the UK stock market, you’d have £23.9 million if you invested £1,000 in 1955. It’s amazing, the small-cap effect.

Why is it there? Because of growth. So, basically, small companies, just because they are more nimble, more agile, their capability to take more market share is there, or grow their businesses. That growth, I don’t think is ever going to change. They are always going to be able to grow.

Now, interestingly, your listeners or viewers will know that of late, the phrase ‘elephants don’t gallop’ has been sort of turned on its head because a company like NVIDIA Corp (NASDAQ:NVDA), which is huge, has clearly been galloping, which is why it’s been performing well.

But we all know that overall and over time, the largest companies, they just run out of room to keep growing. They may have phases, but in aggregate, the smaller ones can grow faster, and grow their profits at a faster pace.

So, I don’t think this effect goes. There is one other aspect to it, which is important, and it is that the smaller part of the UK market, and any smaller company, is more illiquid. And, essentially, the larger flows of money worry about the illiquidity of the asset class. And for that, they put a discount on your average small cap.

But what happens over time is that as those smaller companies get bigger, obviously, the discount narrows because they’ve just become bigger and more liquid. And that kind of supercharges the return on top of the growth.

Now, we could have an arbitrage away of the small-cap effect for a period because what people do is they realise this and then start buying loads of small caps and move small caps to a big premium to large caps in terms of valuation. But I suspect what would happen is you get a phase of excellent returns, and then they’d probably move back to the mean over time.

So, I’m pretty confident the small-cap effect will continue to work over the long term.

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Kyle Caldwell: Let’s now move on to how Rockwood Strategic invests. You’ve already touched on a couple of points, but could you first summarise your investment approach? So, it’s a concentrated portfolio, and you have around five to eight core positions?

Richard Staveley: Yeah. So, we’ve got 25 stocks in the portfolio now, and we’re focused on businesses where we think there’s the scope for operational, strategic, or management change.

At the same point, that change is exposed to businesses, which is cheaply valued, so a low valuation stock. And also one where the profits are depressed, either depressed relative to the company’s own history or to its peer group, or to the potential for its business model.

So, we look for these depressed profits. We look for a low valuation, and then we try and work out are there initiatives or catalysts that could occur that could unlock shareholder value, create shareholder value, recover shareholder value? And that supercharges our returns for Rockwood.

Kyle Caldwell: Could you talk a bit more regarding how you try and unlock value? How involved are you with the companies?

Richard Staveley: Well, not in every instance. For some of them, we don’t have to be either heavy handed or highly involved in the turnaround. Often, we’ve just spotted them because they’re small, they’re off the radar, things are changing, and no one else has spotted it except for us, and we’re just happy with what’s changed.

However, for quite a few of our holdings, we will roll up our sleeves and get stuck in. So, of the 25, 10 have people on the board who we’ve either proposed and then have joined the board, or ourselves if we’ve taken a board position. We’re currently working on two more. I can’t tell you about them today, Kyle, but there will be two more shortly.

Second, we take large stakes. So, of the 25 holdings, for 18 of them, we’ve got at least 5% of the equity. Now, why that’s relevant is because we try and be constructive with management and the boards of these typically underperforming businesses.

We go in, we get to know the business, then we say, look, surely this person is being ineffective, or you need to adapt the strategy or change in some way. Often, if it makes sense, we may just catalyse that to happen and then we all move on with our lives. Sometimes, though, we have to move from a constructive dialogue to writing it more formally to them and setting out what we think.

In some instances, and this is why the 5% of the shares is relevant, we may have to actually threaten an EGM (emergency general meeting) where all shareholders get to vote on the proposals we think would be in the company’s best interest.

Now, that involves a lot of engagement, and we’re not aggressive US-style active funds. From the outset, we’re speaking to the other shareholders, particularly the larger ones. We’re speaking to the board, the management, trying to work out what needs to happen. But as we know with humans, they’re often slow to accept that change is necessary, slow to admit mistakes, and don’t dislike admitting mistakes. Sometimes board members kind of go native. They are meant to be independently pushing the executives to do their best job, but they may get to know them far too well. So, we highlight these aspects.

If there’s broad shareholder support for the changes and they make sense, typically they will end up happening without us having to do stuff in the public domain or noisily through aggressive newspaper campaigns or anything like that.

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Kyle Caldwell: Could you give an example or two of companies in the past where you’ve got heavily involved and it has led to a good outcome?

Richard Staveley: Yes. So, there’s two examples that come to mind that would be really good to speak about.

The first is one of our leading fintech businesses in the UK called Funding Circle Holdings (LSE:FCH). They’ve spent over a £100 million building a technology platform which facilitates the lending of money to small and medium-sized businesses in the UK, something that our high street banks used to do a lot more often than they do these days.

So, these florists, small restaurants and other small businesses that are often family owned, need access to credit and that’s what Funding Circle allows them to do through their platform. They listed a number of years ago - I think Goldman Sachs did the float at a £1.5 billion valuation.

If you roll forward a few years - we bought the shares about two years ago - people felt that they were still making too many losses, and had lost interest in the narrative from the company, and it was trading at a deep discount to the cash the company had on its balance sheet, literally less than the cash that the business had. So, we built a stake.

We engaged with other shareholders, with the board, the management, and we got them to essentially kickstart a buyback policy. They’ve now bought back significant amounts of the equity. We started buying the shares at about 30p, and other shareholders were pretty upset when the shares were around 30p. The finance director was changed, they sold off their loss-making US activities, and they did their first decent cost-cutting programme, which we’d pushed them to do to accelerate the move to profitability.

So, where we are today, as we’re recording this, Funding Circle’s just hit £1.60. The shareholders are very pleased with the recovery. The company’s in great shape, it’s now moved into material profits, and it’s in a really strong position to keep growing as a leading fintech business.

Another one would be Centaur Media (LSE:CAU), this is much smaller business. For a period, I actually went on to the board myself to get to know the business really well and make sure they were focused on shareholder value.

In the end, I chose to come off the board to allow one of the people in the Harwoods network, Martin Rowland, to come in as chair of Centaur Media. Shortly after becoming chair, he became executive chair, and the CEO departed the business. At that point, the shares were about 22p - this was about a year and a bit ago.

Then Martin, with huge energy, as he always does, and gusto, sold off the various disparate businesses which were there in Centaur Media to better homes and people that would acquire them, and we should be returning 48p in cash to everyone in March this year.

Kyle Caldwell: I wanted to end by asking you about one of your biggest holdings, Capita (LSE:CPI), which has been in the news recently. It was reported that Capita’s in a bit of a spot of bother following the Civil Service Pension Scheme that it took over the management of. I think it was towards the end of last year that it took over. Your latest results, at some point last year, suggested that the company was getting back on track. What is your view now in light of recent developments?

Richard Staveley: Yep. So, the company is definitely getting back on track. I think since I said that a year ago, Capita’s now up 90% in terms of shares. We bought it when it was about £225 million market cap. It’s now around a £400 million or so market cap.

For those who don’t know, our view is that the business is going to be eventually valued at over £1 billion. We still think there’s at least a 100% upside in Capita.

If we take the Civil Service Pension Scheme, obviously, it’s a contract that they relatively recently won. They clearly have taken it over when it was in a bit of a mess from the prior guys. I think there were something like 16,000 unread emails and a backlog of 84,000 cases, and they took over the contract on 1 December last year.

So, the transition phase, I think, is through to March, and it’s clearly in a bit more of a mess maybe than they had hoped or expected it to be in. I think they’ve allocated what they call a surge of additional employees to try and deal with the backlog and get that going.

But as usual, because they have got good relationships with government agencies, they put out a joint statement with the Cabinet Office, saying that it’s being addressed and that they’re both working on it.

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Capita, if you own the shares, it touches so many parts of British public life, it’s sort of inevitable that they are going to be in the news a bit trying to do the very best that they can. They run the Student Loans Company, they do the Congestion Charge, the ULEZ zone, they do the TV licence, GP surgeries.

Where I’m really excited about it, which I think people haven’t really fully recognised, is that they are going to be the tip of the spear for AI. I actually think Capita is this hidden AI stock in the UK market because Adolfo Hernandez, the new CEO we’ve obviously backed, and the new board, new CEO, new finance director, new heads of ops, all the rest of it.

They’ve been selling off businesses to pay down the debt, which is now under control. They had a huge pension deficit and they’ve paid that all off…they took on some horrific contracts - not the Civil Service one, they want the Civil Service contract - they took on some loss-making contracts, which they’ve now exited.

Adolfo used to run Amazon Web Services, AWS Europe. What he’s done since he’s joined is announce a series of strategic partnerships with Microsoft, AWS, ServiceNow, and Salesforce to embed AI, not only into how Capita works as a business, but how they deliver on these government contracts.

If we all sit back for a moment and think, what’s the biggest opportunity in Britain now? It’s probably to get the costs of government bureaucracy in the public sector down as much as possible without cutting, if you see what I mean, that’s the more political question.

But in terms of making them more efficient, that’s got to be a massive goal, hasn’t it? And AI is going to play a huge role, and Capita have the relationships and the trust and the contracts with government to really lead huge improvements, we hope, to the provision of government services.

For those listeners who are interested in multiples and things, Capita’s currently on a PE of seven times, a very low single-digit PE. And, again, we think as they continue to deliver improved free cash-flow generation over the next couple of years, that we should see a further re-rate.

Kyle Caldwell: Richard, thank you very much for your time today.

Richard Staveley: Thank you so much too.

Kyle Caldwell: So, that’s it for the latest episode of our On The Money podcast. We love to hear from listeners, and the best way to get in touch is by emailing us at OTM@ii.co.uk.

In the meantime, you can find lots of practical insights related to investments, personal finance, and pensions on the interactive investor website, which is ii.co.uk. I’ll hopefully see you again next week.