The UK equity market delivered a strong performance over the past twelve months (FTSE All-Share +24%), despite the headwind of considerable political upheaval. While most commentary has focused on the boost to foreign earning companies from the dramatic fall in Sterling, less attention has been afforded to the more domestically exposed mid- and small-cap end of the market.
Here we have seen similar, if more fluctuating, performance (FTSE All-Share ex.100. ex. Investment Trusts +21%). This demonstrates The Mercantile Investment Trust plc’s benchmark. Looking ahead we expect a bumpy road but believe the overall outlook for markets, most specifically UK mid- and small-cap, remains positive, with good prospects for long-term capital growth and income.
It goes without saying that the UK faces a period of uncertainty ahead, in terms of how the eventual relationship with Europe will be structured and what impact this may have upon economic growth. We expect this phase of negotiation will lead to oscillations in sentiment between periods of calm and periods of worry but on a medium term view we believe there is considerable value to be found in mid and small sized companies. Indeed any short-term price fluctuations through this transitory period may create a buying opportunity. Ultimately, there are many other factors that will in influence the direction of the market – including of course the potential resurgence in global economic growth. There are a number of UK-listed but internationally exposed companies with market leading positions, particularly in the industrial space, that can tap into improving growth in overseas economies. This has been an area of particular focus for the fund for the past year.
Looking forward to the next twelve months, a key issue will be how the UK consumer adapts to the seemingly inevitable in inflation in living costs brought about by Sterling’s decline. With this imported in inflation, the outlook for the UK consumer is no longer as strong as it was, say, two years ago. However, that does not preclude maintaining selective exposure where the investment case remains compelling or where the business may prosper in just such an environment. For example, the consumer space includes a number of attractive mid-cap opportunities relating to discount retailers and online marketplaces, two business models that are disrupting existing markets and thriving in the process. In general, rising in inflation should be a positive for equities, but it requires fundamental analysis to identify which companies are equipped to deal with increasing costs and best positioned to pass these through to consumers with higher prices.
It is also worth reminding ourselves why exposure to the mid- and small-cap market has been so beneficial over the long term and why we feel this can be sustained in the future. The UK mid- and small-cap market has delivered excellent long-term returns which have outpaced the FTSE 100 in two years out of three for the past 60 years. In our minds, there are three key structural drivers and, whatever the outcome of the Brexit negotiation process, these will remain true.
1. Higher growth
Smaller companies by their nature are better able to generate higher growth which is not as dependent upon the strength of the economy, unlike their large-cap counterparts.
2. Nimble business models
Smaller businesses are more nimble than their larger counterparts and are often better placed to adapt to and even drive structural changes. There are many examples of disruptors in this part of the market, who can challenge incumbents and find creative ways of growing regardless of the macro environment.
3. Mergers & acquisitions
The UK is one of the most open markets in the world. According to the Organisation for Economic Co-operation and Development (OECD), it is one of the easiest markets for foreign firms to do business, and the UK mid- and small-cap market is often viewed as a place to find attractive acquisition opportunities for private equity rms. Sterling’s depreciation should also offer a helpful boon to this trend. Investors could see an uptick in mergers and acquisitions coming from a period of depressed activity in 2016 as a result of Brexit uncertainty. Related to this final point, there has been a healthy amount of corporate activity in recent months, and we expect this to continue.
The Mercantile Investment Trust plc
Fund managers: Guy Anderson (2012), Martin Hudson (1994), and Anthony Lynch (2009)
Launch date: 08/12/1884
Assets under Management (as at 31/03/17): £1,989.3m
Investment style: Blend
Sector: AIC Sector: UK All Companies
Benchmark: FTSE All Share (ex FTSE 100, ex Inv Companies) (£)
Awards: Money Observer – Rated Fund, 2017