The stockmarket has overlooked British small caps with huge potential

Our investment process in the GAM UK Equity Income Fund is focused on stocks of all sizes. The fund aims to provide income and capital growth through investment in predominantly British stocks with an emphasis on cash-generative companies. We meet managers and conduct on-site visits in order to hunt out cheap companies that have been overlooked by the wider UK equity market. 

Our investment process follows four main stages. Firstly, we do cash-flow analysis to gauge which companies have a high cash-flow yield. The second stage, which involves an assessment of the firm’s sector, entails detailed analysis of environmental and social governance (ESG) and also prevents distressed companies from entering the portfolio. The third stage is a management review. This is pivotal, as it enables us to sit down with management teams. Finally, at the fourth stage, we undertake a timing analysis – determining when the stocks should enter our portfolio.

Stronger sterling helps smaller stocks

Global investors have shunned UK equities since the Brexit vote in 2016 – no wonder, given the UK’s well-documented weak growth, low productivity and soaring inflation. Still, we think small and mid-caps should be performing better than they are and the tide is now shifting in favour of British equities. 

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Sterling took a beating following the EU referendum vote, and again in 2022 following Kwasi Kwarteng’s Budget, when it almost hit parity with the dollar. It has since strengthened, yet this is not being reflected in the share prices of the more domestically oriented companies. Although it has since stabilised, the ongoing weakness of the pound, despite higher interest rates, has made it cheaper for UK companies to import goods with production costs priced in dollars.

This is why we are willing to have 50% of the fund exposed to that size of company: the narrative is excessively pessimistic. As a result, more domestically oriented companies are broadly trading on six to eight times earnings.

We have just sold Shoe Zone (Aim: SHOE), a small company that sells shoes on the high street at an average price of £10, to cash in on the 50% return we made on that investment. The company buys its products in Asia and ships them to the UK. It has benefited from rising margins as the price of containers, denominated in dollars, has rapidly declined.

Lucrative lippie 

Another example is cosmetics company Warpaint London (Aim: W7L), whose target market is 18- to 24-year-olds. The stock is a value proposition, as lipsticks are sold for as little as £3. Sales of Warpaint London’s products at retailers such as Tesco, Boots and Superdrug have helped the company record a significant improvement in its business, and the shares have risen against the book price in the fund. 

One more stock to keep on your radar is Strix (Aim: KETL), a kettle and water filtration company. In addition to making the Tommee Tippee baby bottle filter and coffee machines, the firm recently acquired Billi, a hot water-system manufacturer. Although the kettle market has struggled with customers running down stock levels, these are now building up again. Ultimately, Strix will benefit from growing demand from households for water filtration.

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