Deal or no deal? What does it mean for UK smaller companies?

Dan Nickols, manager of the Merian UK Smaller Companies Fund, believes smaller UK stocks are likely to benefit disproportionately from a Brexit resolution.

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  1. Rob Morgan

The sand in the hourglass is all but gone. In a matter of days we should know whether a trade deal has been agreed between the UK and the EU or whether we will enter 2021 without one. The political and economic consequences are clearly significant, but despite fears of short-term disruption, delays and slowdown, UK fund managers are largely sanguine about the investment prospects.

Deal or no deal, the end of negotiations should lift some of the uncertainty that has cast a shadow over UK equities for the past five years. At the very least it will finally allow investors to better assess the risk of UK equity investments with the knowledge of what the future trading relationship with our biggest partner looks like.

Dan Nickols, manager of the Merian UK Smaller Companies Fund believes the difference in short term economic impact between a thin, goods-only free trade deal (which appears the only type of deal likely) and ‘no deal’ will probably be minimal. He explains that even in a ‘deal’ scenario, frictionless trading in goods with the EU will be lost, with the red tape of goods inspections becoming the norm. He also points out that negotiations between the UK and EU exclude services, where the UK currently enjoys a sizeable trade surplus.

There also may be some more positive news in the pipeline for embattled UK businesses. The UK government has yet to set out how it might deregulate certain areas, and Nickols believes this could serve to offset some near-term negative effects of the loss of frictionless trade with the EU. Developments regarding future international trade deals are also awaited and could provide some opportunities for certain sectors and companies.

Market reaction

It is difficult to anticipate how the stock market might react in the coming days and weeks. Bookmakers’ odds of a trade deal being negotiated have lengthened in recent days as leaders failed to break the impasse. While it was always likely to go the 11th hour, the tone of announcements from the two sides has become more pessimistic. However, the market reaction has thus far been muted suggesting that a ‘no deal’ scenario is either baked into valuations, or that it matters less than other factors dictating market action such as the pace and success of the Covid-19 vaccine rollout. The value of the pound in currency markets is also a factor to consider. Weakness in the currency can be positive for businesses with significant overseas earnings.

Nickols expects any resolution of Brexit to give rise to an “unwinding of the uncertainty discount” that has held back the UK compared to other developed world markets since the referendum result. He suggests the reaction in the short term could be most positive among more domestically exposed, consumer-sensitive areas, which have underperformed since the referendum – many of which reside in the medium-sized and smaller company space. This could be driven by the return of overseas investors, whose interest in the UK equity market has waned since the referendum, attracted to the discount at which the UK market currently stands. Nickols suggests this is at around 18% to Europe and 36% to the US based on a 12-month forward price/earnings (a ratio that measures next years’ likely earnings against current value).

Growth vs value

As developers of Covid vaccines started to report encouraging initial clinical trial data, there has been a sharp rotation within markets favouring ‘value’ businesses whose share prices seem relatively cheaper over growth companies whose revenues are growing relatively faster. Having underperformed for most of the year the ‘value’ part of the market – generally the more economically sensitive areas – recaptured much of its 2020 underperformance in November.

Dan Nickols believes the potential for ‘value’ to continue its recent rate of outperformance will be limited, not least because, following the recent rally, many of the more economically sensitive businesses now trade much closer to average historical levels. He also suggests the pandemic has accelerated many of the structural tailwinds supporting disruptive, growth-orientated, often online businesses. As behavioural shifts have become embedded as a result of life under lockdown the outlook for their earnings has improved.

Consequently, the manager is keeping his portfolio tilted towards the more expensive businesses offering growth. However, given the wide range of possible economic outcomes heading into 2021, he is also complementing this with selected cheaper, more economically sensitive businesses that are well managed and are in a strong financial position.

Our view on Merian UK Smaller Companies

We continue to admire the highly experienced and stable UK Mid and Small Cap team at Merian, which is essentially undisturbed following the merger of the fund group with Jupiter Asset Management this year. Although one of the larger funds in the sector, which restricts the extent to which the manager can access the UK’s smallest companies, we feel the fund still has the potential to outperform its benchmark and peers given the quality and experience of management team. The fund is part of our Foundation Fundlist of preferred investments across the major sectors.

Past performance is not a reliable guide to future returns. This website is not personal advice based on your circumstances. No news or research item is a personal recommendation to deal. Investment decisions in fund and other collective investments should only be made after reading the Key Investor Information Document or Key Information Document, Supplementary Information Document and Prospectus. If you are unsure of the suitability of your investment please seek professional advice.

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