Small caps: how to ride the recovery wave of UK equities

City of London financial district with Royal Exchange building

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British small caps have demonstrated remarkable resilience, outperforming blue chips over the past year. Fuelled by a surge in takeover activity, investors’ interest in the sector has ignited – yet stocks remain materially undervalued. With a backdrop of anticipated interest rate cuts and a new government committed to stability, we believe the stage is set for investors to capture long-term growth in this asset class.

Our focus is on this “sweet spot” of UK equities. By taking significant stakes in our holdings, we can use our private equity expertise by engaging with firms’ boards to support value creation. This approach enables us to curate a concentrated portfolio of exceptional companies in structurally growing sectors.

British small caps: a wealth of opportunity

The UK wealth-management sector is a burgeoning market, underpinned by robust structural growth drivers including rising household wealth, a persistent advice gap and supportive government policies. Despite the sector being “out of favour”, well-positioned businesses that can weather the storm will emerge stronger as inflation cools and interest rates decline, stimulating positive fund flows.

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Brooks Macdonald (Aim: BRK) is a prime example. Its recent transformation and investment initiatives have positioned it for robust asset growth and improved profitability as market conditions improve. While we do not base investment decisions on potential takeover speculation, note that the sector’s consolidation is driven by private equity’s interest in high-quality businesses at attractive valuations. This dynamic provides a degree of downside protection. However, we anticipate that the market will eventually recognise the company’s exceptional qualities, leading to a substantial rerating of its shares.

The UK residential lettings market is experiencing several favourable long-term trends. These include the challenge of home-purchase affordability (exacerbated by elevated interest rates), the relative lack of new construction and the depressed supply of rental stock.

The Property Franchise Group (Aim: TPFG) has just become the UK’s largest franchised multi-brand estate agency group through its merger with Belvoir Group.

TPFG generates its revenue by collecting franchise fees in exchange for a suite of support services, which provides TPFG with a highly attractive and resilient earnings profile throughout market cycles. In addition, as UK residential housing sales volumes begin to recover, TPFG is well placed to benefit through its sales and mortgage-broking exposure. Green shoots of this cyclical recovery are evident, with TPFG reporting a 16% like-for-like increase in its pipeline of agreed sales in June 2024, marginally ahead of the 15% recorded for the wider UK residential housing market.

Costain Group (LSE: COST), a leading infrastructure engineering and consultancy services provider, should capitalise on several tailwinds. The state’s substantial £700 billion infrastructure investment pipeline over the next decade presents ample growth opportunities across Costain’s core markets of transport, water, energy and defence. Furthermore, the increasing emphasis on sustainability aligns perfectly with the company’s record of delivering positive environmental and social outcomes.

The adoption of industry best practices, as outlined in the government’s Construction Playbook, is shaping the market in a way that favours Costain’s expertise in risk management and operational excellence. Costain’s strong balance sheet provides scope to invest in growth initiatives and navigate potential industry challenges.

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Ken Wotton is lead manager of Strategic Equity Capital plc and Managing Director, Public Equity at Gresham House and leads the investment team managing public equity investments. Alongside this, he is manager for WS Gresham House UK Micro Cap Fund, WS Gresham House UK Multi Cap Income Fund and manages AIM listed portfolios on behalf of the Baronsmead VCTs. Ken graduated from Brasenose College, Oxford, before qualifying as a Chartered Accountant with KPMG. He was an equity research analyst with Commerzbank and then Evolution Securities prior to spending the past 12 years as a Fund Manager at Livingbridge and now Gresham House specialising in smaller companies.