The answer to your FOMO blues

It seems like barely a week goes by without a bid coming in for a UK listed company. The latest takeover came last week, when the Danish brewer Carlsberg agreed to buy Britvic, which makes soft drinks including J2O and Robinsons, for £3.3 billion.

Private equity, corporates and trade buyers are cashing in on the cheapness of UK plc while they can.

There were 31 bids that were announced in the first half of 2024 and that are still live for companies outside the FTSE 100, worth a total of £37.4 billion, according to Peel Hunt. The median premium of those 31 bids was 28%.

In other words, UK small and mid-cap is cheap and outside buyers are cashing in. The forward price-to-earnings ratio of the Deutsche Numis Smaller Companies (ex Investment Companies) Index, excluding loss-making companies, is 13. This is below its long-term average of 15 and lower than most of the world’s major markets, including the US, Japan, Europe and emerging markets.

This, of course, is nothing new to readers of Kepler Trust Intelligence. Smaller companies across the world are cheap relative to large caps and UK stocks in general are cheap versus most of the rest of the world. But that’s been the case for a long time now.

So why should I care, I hear you ask. Well, it’s looking increasingly like we can see the catalysts for a UK small-cap revival coming through – and the M&A activity is, in our view, evidence of that.

Why is activity accelerating now? Well, share prices are starting to rise in earnest. Since its late-October low, the FTSE Small Cap Index is up 20%. Perhaps there’s some FOMO from private equity (which, don’t forget, still has plenty of dry powder on hand) that if they don’t get their cash into the market and snap up their targets now, they’ll miss the next 20%, too.

The companies being bid for represent a broad range of sectors of the UK economy – from real estate and building products through to packaging and logistics firms – and the potential acquirors include private equity funds, trade buyers and corporates, both domestic and overseas.

A beacon of stability

Then, there’s the political situation: whisper it, but with populists making gains in the French election and November’s polarising US presidential election, the UK might finally look like a beacon of political stability.

Prime Minister Sir Keir Starmer’s Labour party has seemingly positioned itself as a centrist government – New Labour Mark II, if you will. New Chancellor of the Exchequer Rachel Reeves has put driving economic growth as her number one priority and expects to work with the private sector to build new housing, infrastructure and energy provision among other things.

Invesco Perpetual UK Smaller Companies (IPU) is well placed to benefit from these catalysts and any upturn in a UK small-cap revival that they might bring.

Managers Robin West and Jonathan Brown look to create a portfolio of quality, small-cap companies that are trading at attractive valuations and have the potential to grow over time. The quality factors they look for include companies with pricing power, well-tested management teams, and resilient balance sheets.

The portfolio blends defensive businesses, which have more robust earnings profiles and can better endure broader macro weakness, with more cyclically exposed businesses, which are trading on low valuations but are better placed to capitalise on an economic recovery.

The characteristics that Robin and Jonathan look for tend to also be what private equity and trade buyers look for.

That’s been borne out by the fact that two of their holdings – the video games maker Keywords Studios and the financial consultancy Alpha Financial Markets Consulting – have been snapped up by private equity firms in the past four weeks alone. The premiums paid by acquirors EQT and Bridgepoint were 69% and 51% respectively.

Other take-outs the portfolio has seen include Gresham House, The Restaurant Group and Ergomed, while XP Power and Crest Nicholson have both rejected takeover attempts.

Consumer confidence

In addition, IPU has exposure to several stocks in areas likely to benefit from any opening up of the planning system needed to build new houses and upgrade our infrastructure.

These range from pure-play housebuilders like Crest Nicholson and MJ Gleeson, to those further down the supply chain including Volution, which manufactures ventilation equipment for homes and offices, and Hill & Smith, which makes and supplies products to the construction and infrastructure markets.

A third area of interest is the consumer. We’ve all been under the cosh since the cost of living crisis hit through 2022, but things seem to be improving. Wages are now growing faster than inflation, while former Chancellor Jeremy Hunt’s cuts to national insurance should start to be felt in the coming months.

Stocks in the portfolio such as Loungers, which operates café-bars around the country, Hollywood Bowl, the ten-pin bowling operator, and AJ Bell, the investment platform, could benefit here.

One of IPU’s points of differentiation is its enhanced dividend policy, which was established in 2015. The policy is to pay four quarterly dividends that pay a yield equal to 4%, based on the share price at the end of the prior financial year (31st January).

This amount comes from a blend of the underlying income generated by the portfolio and a contribution from capital. Historically, the portfolio has generated approximately half of the required income, though as a result of low market valuations, the running yield of the portfolio is currently quite high meaning less is likely to be required from capital.

IPU currently sits on a discount of 16.6%, which is wide compared to the average discount since the enhanced dividend was introduced almost 10 years ago.

Amid the column inches about just how cheap UK smaller companies are, it’s easy to forget the power of the small-cap premium that has been witnessed over the years. Since 1955 the Deutsche Numis Smaller Companies (ex Investment Companies) Index has seen a compound annual growth rate of 14.1% to the end of 2023, versus 11% for the FTSE All-Share.

That might not sound like a lot, but it is: £1,000 invested in 1955 would be worth £9.2 million if invested in the small-cap index, but just £1.4 million if invested in the FTSE All-Share.

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