Some early reasons for cheer in 2023
Rate-hiking cycles are a difficult environment for smaller companies as investors’ anxiety about the growth outlook and economic resilience rises to the surface. So the last year has been hard, particularly for the more cyclical companies and those in sectors sensitive to rate rises.
The rising rates backdrop has also served to place further pressure on the relative performance of small companies versus large, in the equity markets. As small cap investors it is welcome news, therefore, that inflation appears to be easing back, which in turn infers that we may be nearing the peak of the current interest rate cycle.
The pattern of a harder hit for smaller caps in a rising rates cycle has historic precedence but so too does another that shows once investors begin to discount recovery, a period of outperformance tends to follow. This is especially the case if monetary policy is loosened, making access to finance cheaper and easier for smaller companies.
Not a focus, but sometimes a helpful by-product
Another, longer-term, more structural supportive factor for smaller companies, is their relatively higher chance of attracting takeover interest compared to their larger peers. While in the stock selection process our focus is, and has always been, the core fundamentals and growth potential of the business and company we are investing in, we have over the years seen many of our investments attract the attention of larger peers or private equity companies.
In The Global Smaller Companies Trust’s last financial year, to the end of April 2022, there were no fewer than 17 takeovers or mergers across the investment portfolio. The UK and US markets were particularly active with valuations of UK small caps becoming increasingly attractive to overseas acquirers as sterling came under pressure. We’re not expecting a similar, elevated, level of activity to be repeated in the period ahead. This is not least because cost-of-living pressures and inflation make for an uncertain economic environment and the higher costs of capital present a greater challenge to leveraged private equity deals.
Pockets of consolidation will continue
A lot of consolidation has been seen in the wealth management segment in recent years and the Trust’s NAV performance has benefited from the takeovers of UK based IFA consolidator AFH Financial Group, by private equity, in 2021 and the acquisition of Brewin Dolphin, by RBC, in 2022. Early 2023 indications are that this sector remains active. Despite the higher cost of funding deals we have recently seen confirmation of a potential private-equity-backed approach for another of our holdings; US listed wealth management consolidator Focus Financial Partners. There have also been rumours of interest in another of our portfolio holdings, the health care services business Catalent.
It’s important that shareholders receive fair value when companies are taken over and with the share prices of some smaller companies still trading well below previous highs, there is a risk that deals could be concluded at an unfavourable price point. While takeovers tend to offer a premium to the prevailing share price pre-announcement, they may not always be that attractive compared to the alternative of the status quo, if the existing management team have a sensible medium-term strategy.
Small size no barrier to ambition
In a separate development relating to one of our holdings in the FTSE 250, listed information and events group Ascential has announced that it is looking to spin off its digital commerce arm via a US listing. The management team are hoping that a higher value is placed on the business by US investors than has been the case by domestic holders. The news has initially been warmly received by the market.
There are even some faint signs of life in the IPO (initial public offering) universe, after a dearth of activity in most markets in 2022. These are just a few of the reasons why we are hopeful that 2023 can be a more positive year for equity markets and the smaller companies within them.
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