Follow the money! Investors should pay attention to cheap UK smaller companies being snapped up
Investors should sit up and take notice of why private equity firms are snapping up cheap UK smaller companies, fund managers say.
The UK's stock market listed smaller companies are repeatedly becoming the target of takeover activity, as bargain share prices and a lack of interest from investors offer a chance for private equity buyers to grab value.
But the lack of upbeat sentiment from big investors provides an opportunity for smaller investors to profit, says Abbie Glennie, co-manager of Abrdn UK Smaller Companies Fund and the Abrdn UK Smaller Companies Growth Trust.
He said: 'These discounts reflect the negative sentiment that we've seen towards UK smaller companies in recent times. True it's been a tough period for the sector – with weaker performance and tightening regulation. But ultimately negative sentiment is just that – sentiment.'
The average premium paid in small cap takeovers compared with undisturbed share prices over the past 18 months is over 50 per cent, according to Ken Wotton, of Gresham House's Strategic Equity Capital.
Clearly, buyers think there is value in UK small caps that investors aren't seeing.
'The UK is at multi decade discounts relative to global equities,' says another small cap manager, says Wotton. 'Depending on how small you go, the discount of smaller companies versus larger ones gets bigger.'
Data from Aberdeen indicates that UK smaller companies are significantly undervalued based on 12-month forward price to earnings ratios compared with the ten-year average.
Looking cheap is true for smaller companies around the world, says Aberdeen, with small caps trading at discounts globally: European small caps at a 28 per cent discount, US small caps at an 26.9 per cent discount and Japanese firms 19.4 per cent lower.
But the tide may be turning on UK small caps. These are trading at a discount of 14.6 per cent to their ten-year average, after strong performance over the past month. Whereas, in March, the discount for UK small caps was the largest of any major market at 23.4 per cent.
The uptick for UK smaller companies could reflect investors finally paying attention to a raft of buyouts and major investments.
The highest takeover activity was seen within the tech, media and telecoms sectors, while consumer goods and retail also saw an uptick.
Glennie added: 'Confidence in the US 'mega caps' has waned and investors are looking for ways of reducing their exposure. So interest in other asset classes is increasing.
'Within the UK, people are more favourable towards domestically focused UK companies than we've seen in many years. All this could be positive for UK smaller companies.
'So far we haven't seen this transform into a major shift in sentiment towards UK smaller companies and flows into the asset class – but the foundations for a turnaround are being laid.'
Compared with private market valuations, small caps on public markets are trading at discounts of around 30 per cent. In some cases, Wotton says, these discounts reach 50 per cent.
'That's creating a big dislocation gap arbitrage opportunity between private markets, international markets and the UK small Caps,' Wotton said.
It is this disparity between prices that is creating interest from potential buyers and leading to elevated takeover activity in the sector.
Wotton said small cap buyers range from US and European private equity firms to corporate strategic buyers from the UK, Europe and the US.
'The consistent theme is not who's buying, the consistent theme is the valuations of what's being bought,' Wotton said.
What do takeovers mean for small caps?
As long as UK small caps are widely undervalued, they will remain potential takeover targets.
'I would expect takeover activity to continue to be elevated,' Wotton told This is Money.
'I think that what changes it will be valuations moving up in the UK, small cap sector or alternative valuations moving down in other areas.'
Wotton adds: 'It's clear that there are valuation opportunities there because that's why there are takeovers happening at a premium.'
There are concerns that one effect is that the UK small cap market is gradually being hollowed out by private equity buyouts and delistings. A downturn in UK IPO activity is also compounding the dire situation the small cap market finds itself in.
Some firms are breaking that cycle, such as the listing of a new British bitcoin holding company, by Smarter Web Company, but these instances are rare.
Last year, Peel Hunt said the FTSE SmallCap index could cease to exist by 2028 if current trends continue.
An extreme scenario, perhaps, but Wotton says there is little indication that investors are changing their minds on small caps.
He said: 'I've been expecting the elevated level of takeover activity over the last couple of years to be the catalyst which really shines a light on this valuation discrepancy and attracts more money back into the UK small cap market.
'That hasn't really happened and you've seen instead you've seen this kind of relentless month on month on month outflows from UK funds.'
How to profit from UK smaller companies
Fund managers, Wotton says, aren't powerless to stop their holdings falling victim to opportunistic takeovers.
Strategic Equity Capital, the investment trust that Wotton manages, zeroes in on the long-term fundamentals of the firms it invests in, 'trying to cut out the noise of short term sentiment' and 'really focus on the long term business fundamentals and quality companies trading at attractive prices'.
However, beyond this, Wotton says the key is that Strategic Equity Capital is prepared, and willing, to actively engage with companies they invest in.
Strategic Equity Capital, Wotton said, is willing to take higher stakes in businesses, allowing them to be proactive in engaging with the companies.
He said: 'We make a very clear distinction between activism - we do not consider ourselves to be activists - and constructive active engagement, which we do consider ourselves to deploy.
'This means working with management teams and boards that having an input into key issues which we think are really important for shareholder value perspective such as the business strategy, capital allocation, board composition and management incentives being aligned with shareholder value over the longer term.'
Being engaged, he says, also allows them to make introductions to people or firms that can help specific companies, as well as to 'support value creation and hopefully add value ourselves along the way.'
The aim of this, of course, is to improve small cap valuations to a point they can't be snapped up at discounts by private equity firms.
However, this strategy can also help to fight off unwelcome takeover attempts.
He adds: 'In an environment where there's lots of takeover approaches, some of which are quite opportunistic because of the low valuations, the last thing that we as a shareholder or the management team or the board want is for someone to come along at a 30 per cent premium to a depressed price and then shareholders capitulate and the company gets sold.'
'Where we've got a big stake, potentially we can, we can block that from happening and we have done that in a few situations.
'So as a board, if you have good supportive dialogue with [an investor] then you know that as long as you're doing the right things and it's aligned with what we all kind of agreed is the right thing to do, we're not going to capitulate in that situation.'
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