Why It’s Time to Get Back to Basics

Why It’s Time to Get Back to Basics

by Richard Bullas, Vice President Portfolio Manager and Research Analyst, Franklin UK Equity Team

In a world of rapid change, it can be easy to lose focus and chase the next big thing. When it comes to investing in smaller stocks, Richard Bullas, vice president, portfolio manager and research analyst, Franklin UK Equity team, thinks investors should go back to the basics and focus on the fundamentals. He explains why he’s sticking with a bottom-up approach and focusing on individual companies in his search for small-capitalisation value opportunities.

The first half of 2017 proved to be an engaging time for the small-capitalisation (small-cap) end of the UK market. After a tough period, we’ve seen small caps reassert leadership over the wider UK market.  We’ve seen a reduction in recessionary fears and concerns over sterling weakness that had initially benefitted large-cap multinational companies.

The investment backdrop in the United Kingdom has, in our view, has remained fairly supportive. Economic and corporate news flow has been generally reassuring. UK gross domestic product appears reasonably healthy, albeit exhibiting signs of slower growth. Unemployment and interest rates remain low, while the recent bout of sterling strength has shone a favourable light on small caps due to their domestic bias.

As investor confidence has increased, there’s been a willingness to take on extra risk within the small-cap space. Investors are searching for extra returns within a generally lower-growth, lower-return environment. This has led to a period of strong demand for growth stocks, particularly those companies exhibiting superior growth characteristics (i.e., structural-growth companies, industry disruptors, technology innovators, and companies with the potential to gain significant market share). This has led to a big rerating—when investors are willing to pay a higher share price—in many of these types of companies. A number of these larger, more liquid names are listed on the top end of the FTSE AIM market, which has outperformed other small-cap indexes.1

We’re seeing evidence of a return to growth and momentum investing taking precedence over fundamentals. However, we see amber lights starting to flash on some stocks trading at historically elevated valuations. As a result, our active, focused and stock-specific investment approach becomes increasingly important in order to navigate this environment.

Company fundamentals, valuations and balance-sheet strength are always at the forefront of our minds. We look for investments that we think should do well regardless of the economic cycle, and where the entry valuation isn’t already capturing the majority of the upside potential.

A Buoyant Period

We’ve been able to find some interesting new ideas within the initial public offering (IPO) market. The increase in the number of companies looking to list on the stock market is a marked change from the wait-and-see stance many companies adopted in the immediate aftermath of the Brexit vote last year. This pent-up demand has provided a window of opportunity to selectively invest in new stocks. We’ve seen a good mix of what we view as quality companies across a range of sectors, priced sensibly and attractively.

Merger-and-acquisition (M&A) activity has also been buoyant. Businesses have been looking to acquire for growth or to divest in order to improve company focus and quality, such as balance sheet strength and profitability. Companies looking to raise new equity for acquisitions can also be a source of new investment opportunities.

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