Investors looking to take advantage of takeover interest among UK stocks should put money into Fidelity UK Smaller Companies (B7VNMB1). It has an outstanding performance track record, scoring in the top 25% of funds in its category over three, five and 10 years.

On a three-year view the fund has achieved annualised returns of 26.5% which is perhaps better than one might expect on a longer-term basis. Returns were helped by the recovery from Covid lows.

However, the 10-year annualised return of 11.1% is particularly impressive given smaller UK-listed firms have endured a decade marked by the Scottish independence referendum, Brexit and the pandemic, all events which disproportionately impacted this part of the market.

Consequently, valuations are cheap, which helps explain why private equity bidders have been highly active in targeting UK small and mid-caps. Manager Jonathan Winton says: ‘We’re looking for companies which are under the radar and potentially enduring a period of difficulty where I can see a positive change dynamic over a three or five-year view.’

Winton explains that he tends to invest when shares have declined significantly and when he perceives margins have not peaked.

A portfolio of approximately 100 holdings ensures lots of shots at the goal with different companies likely to show earnings improvements at separate times, according to the manager.

Winton steers clear of structurally declining businesses. He will invest in indebted firms but these tend to be smaller position sizes until he is comfortable the balance sheet has improved. Areas like cash generation and accounting are also an important part of the due diligence.

The manager does not pursue a buy and hold approach, instead recycling capital into new opportunities once the valuation is ‘pricing in what the company is capable of’.

He expects M&A to be a continuing theme with private equity prepared to look through the current economic uncertainty due to its firepower and the big discount UK small and mid-caps trade on. But although his potential universe is shrinking, he sees no lack of opportunities.

Current holdings include manufacturer Essentra (ESNT) ‘which has changed from three businesses to one high quality business which is potentially undervalued’ and several support services firms which Winton notes are very ‘unloved’.

The top holding is a money market fund, which is just a more efficient way of managing the cash the fund has on hand to make investments. Ongoing charges are 0.92%.

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