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Navigating the Turbulent Waters of UK Small and Mid-Cap Markets

Turbulent Stocks
Written by Andy

October 2023

In light of the recent market turmoil in UK small and mid-cap stocks, it appears quite challenging to identify even a handful of related shares that aren’t currently caught in a downward trend. This trend reflects the broader difficulties faced by these market segments, likely influenced by a combination of economic and political factors.

I’ve noticed a significant uptick in share buyback activities among companies lately. While share buybacks can theoretically boost a company’s stock price by reducing outstanding shares, it’s become evident that this strategy doesn’t always translate into success, especially for companies already struggling, as their stock prices continue to plummet.

This has bothered me for a long time now. I used to be bothered about companies buying back their own shares at high price levels and thought they should be buying at low levels like at present for instance. But I can see now that it is like running water into a bucket with a big hole in the bottom and think that companies should have been giving that cash back to the owners of its shares. Especially when dividends on average have been at a far lower percentage than inflation. Basically, the practice is dishonest as the only ones to benefit are company directors who get some protection for their bonuses from it.

Is it just my watchlist & holdings or are a heck of a lot of companies doing share buy backs right now? Most of these are bombed out companies buying at historically low levels that seem to keep getting lower! Buying companies hoping for a takeover or at a NAV discount (or just a low PE and/or high do yield) as a value investor doesn’t seem to be going well of late but there has to be a bottom somewhere on a lot of these!

A quote from Judith MacKenzie, Head of Downing Fund Managers and Partner of Downing LLP, today as their small company investment trust Downing Renewables & Infrastructure Trust (LON:DORE) gets put into wind-down:

“The decline and demise of the smaller companies’ markets in the UK are now part of the daily narrative of the ecosystem. The facts are stark:

  • The number of UK-listed companies has halved since 1997. New issues have fallen by 33%. 2022 was the worst year for new issues since 1980.
  • The UK equity market has shrunk relative to GDP over the last 20 years. From 104% of GDP to 94%. Meanwhile, the US has increased from 101% to 156%.
  • The reasons why this de-equitisation continues are multiple and complex, however, they point to one thing. There are more investors (institutional and private) selling small companies than buying them. This needs to change before sentiment towards small companies improves.
  • The UK market is dominated by traditional sectors, with just 16% coming from companies that would be described as growth (vs 42% in the US).
  • UK growth companies rely on non-UK investors for 60% of their funding (and more than 70% for deals larger than $100m).
  • Pension fund allocation to UK companies is at the lowest level in history.”

Very potent stuff in this report: “tiresome”, “dispiriting”, “depressingly low”, “glum”. All of it results in a managed wind down. So a further drag on the smaller caps with Downing looking to exit their holdings here. Is this the time to sell though? They might be caving in close to the bottom here. There are little pockets of bullish moves around. The market is comfortable with rates having topped out, rates being normalised higher (post the QE party), rates being higher for longer, inflation being more stubborn than expected and a low growth environment – for possibly many years to come.

Liquidity Crisis: The Silent Threat to Market Stability

Equity withdrawal statistics have also entered the picture, leaving us wondering whether this practice is effectively preventing further declines in share prices or if it’s merely a temporary measure.

For value investors, the landscape has become less predictable. Traditionally sound strategies, such as looking for companies with low P/E ratios or high dividend yields, haven’t been performing as expected in the current market environment.

One of the most pressing concerns is the dearth of liquidity in the market. It’s alarming to observe nearly non-existent fund buying, coupled with trading volumes that are significantly lower compared to previous years. This lack of liquidity contributes to the ongoing downward pressure on share prices.

Anyone using a stop loss especially in such negative markets has to be spot on with the buy point. Personally, I’d rather wait for the trading update and pay 5-10% more if it gaps up than randomly buy if it’s in a downtrend. It removes, at least short term, the chance of a profit warning. Long term holders can just hold if they still see good prospects and they’re looking out 5 years or so. Though I’d say quite a few long-term holders are really traders.

You have funds with redemptions dribbling out persistent sells. Some of this gets mopped up in buy backs but all it is doing is stopping prices falling further. There is almost zero fund buying and volumes are well below 50% of a couple years back. So cash rich companies are enhancing their EPS through buy backs but the PER gets persistently de-rated so net effect is still down. Until buying returns none of this changes irrespective of buy backs.

We saw a couple of weeks back around £250m of inflows (highest in 18 months) as interest rates were seen to peak. This put a rocket under a number of shares as the liquidity effect reversed gear. However, it was short lived and with long dated rates rising again we are back to where we started. At some point, in the UK, my guess is we are going to see some very big gains as liquidity returns but it will probably be a very fast re-rate to more historic levels. Quite when that will happen though who knows…

While there was a brief period of optimism with around £250 million in inflows coinciding with the perception that interest rates had peaked, this boost proved to be short-lived. The subsequent rise in long-dated rates undid the initial gains.

It’s a continued tough market. Hard to keep hitting the trades in this market. I try but exit quick if they go flat or look weak – loving to take little losses works in the long run. Some pop now and again, which is nice, but it’s still a grind until sentiment and flows change. Having said that, its a more optimisic feel of late with some nice oversold/relief type bounces on a further hand, but huge overhang sellers continuing to restrict bounces and any major moves on another. The macro factors stablising (not great of course) now likely allowing the market to focus more on each individual company on a further hand, but flows and sentiment and talk of the death of the UK small cap market on another.

Looking ahead, my opinion is that we may witness substantial market gains in the UK once liquidity returns. However, the timing of this potential recovery remains uncertain, leaving us with more questions than answers. But good luck with the trading! We’re all in the same choppy watered boat until better times come.

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Andy

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