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Rising rates and small-caps

Posted by Jason Rolf on 11/Aug/2014

Despite some hesitation over forward guidance, the Bank of England (BoE) has made it clear that the current record low rate of 0.5% may not see out a 6th year. The exact timing of these moves is going to be hard to predict; a multi-speed housing market and stronger economic growth are finely balanced by a heavily indebted population. It won't be straightforward.

UK growth appears to be returning to normal and the expectation is for interest rate rises to be small and progressive, possibly starting as early as the end of this year with a steady run up over the years to a more "normal" 2.5% - 3%. The BoE, mindful of the risks of snuffing out a recovery from "The Great Recession" too early will be watching inflation carefully especially its effect through wage growth.

The wider market, including small cap stocks, normally anticipates economic growth at the early stages of the business cycle, which has already been reflected in the exceptional returns seen since 2009. However, once the BoE finally gets around to tightening it is likely that economic expansion will be well entrenched, a generally positive environment for small caps which can continue to grow revenues, earnings and dividends.

The risks of an over-tightening or going too quickly cannot be ignored. It may force a higher discount rate to be used in stock valuations, which would need to be offset by higher levels of earnings growth. The earliest stage companies might suffer the most because of their greater dependence on earnings streams projected further into the future. However, the likelihood of this is low, as the BoE will want to avoid speculation on a stronger currency and a premature stalling of the recovery. Increasing strength of the pound versus the Euro may be popular with holidaymakers but it's an unwelcome headwind for UK exporters, especially as 10-year Euro rates are touching record lows of just above 1%.

A backdrop of higher rates is not all bad news as the trading performance of many small companies may not be so tightly linked to interest-rate-sensitive factors, rather growing as a result of niche industry-specific developments. Smaller companies are also, typically, less dependent on debt than larger ones, mainly because debt is harder to access, and more expensive for them. The managers at Amati generally seek to invest in companies with net cash, or modest levels of debt, where there should be a high tolerance to rate rises, or even a benefit from earning more interest on cash.

The effect these rises have on the actual trading conditions for business is nuanced. The portfolio weighting in consumer sectors, such as car retailers Cambria (CAMB) and Vertu (VTU), remains high, reflecting our view that consumer demand will follow higher output, and rising employment will bring with it higher wages. These companies are typically still seeing upgrades to earnings forecasts.

Housebuilders are obviously sensitive to a changing rate environment but are still seeing upgrades such as Telford Homes. However, not all consumer exposure is so interest-rate sensitive: Goals Soccer Centres (GOAL), Dignity (DTY), the nationwide funeral group, and Cineworld (CINE) have both proven to be relatively less cyclical in terms of underlying trading in the past.

High growth structural plays can be another way to reduce sensitivity to rates. Examples in the portfolio are: Regenersis (RGS) the electronics repairer and recycler; Optimal Payments Systems (OPAY), the electronic payments processor and e-wallet provider; and Earthport (EPO), the international foreign exchange payments platform.

In summary, we still like UK domestic exposure, with reasonable exposure to certain consumer segments which are seeing strong trading, but in the context of a well diversified portfolio. The expectation of higher rates in the UK may act as a headwind in the near term, and it would be reasonable to expect this process to be accompanied by a good deal of nervousness. It doesn't feel like a time to be too brave in the stock market, but the companies which can capture the growth in particular markets effectively should still prove rewarding.