Investors in UK smaller companies are justified in feeling impatient. The turnaround in the sector has been slow to arrive, and poor sentiment has persisted far longer than justified by the on-the-ground experience of most smaller companies. However, a number of factors are coalescing that may improve sentiment towards this unloved part of the market.

It has long been clear that low valuations are not, in themselves, a reason to predict an imminent turnaround for UK smaller companies. This part of the market has been cheap for some time and, even as earnings for many small companies have improved, it has only got cheaper. Today, the FTSE 250 has never been as cheap versus the FTSE 100. The sector has continued to experience painful outflows.

Nevertheless, we see signs that the market has found its floor. Smaller companies recovered strongly from their lows in October 2022 and October 2023 and, for the investment trust sector, discounts have started – tentatively – to improve. This is encouraging.

Improving earnings growth

We see an increasing differentiation within smaller companies, with an improving earnings growth picture for the stronger, higher quality smaller companies versus their peers. While many companies had a tailwind during the Covid recovery period, growth has been harder to find more recently. We believe in a world of lower growth, the market is likely to reward those companies that can grow earnings organically and not be dependent on external factors.

Our priority is to find companies that are in charge of their destiny. In the retail sector, for example, we hold Games Workshop and Hollywood Bowl, which have shown themselves able to generate strong recurring revenues in spite of a tougher time for consumers. Bytes Technology is an IT solutions and services company, aiming to help companies achieve maximum efficiency. At present, investors do not have to pay a significant premium for higher quality companies and this, in our view, is an opportunity and could change sentiment towards parts of the smaller companies sector.

Challenging economic backdrop

There have been two key sources of poor sentiment towards UK smaller companies. The first has been the lacklustre UK economy. It may not be strictly true, but smaller companies tend to be perceived as more domestically focused, and therefore more vulnerable to the UK’s economic weakness. The second has been rising interest rates.

While UK economic growth is unexciting, the country only experienced a very short-lived and shallow recession at the end of 2023 and activity revived in January . The sticky inflation problem that has weighed on growth is now ebbing, with the Consumer Prices Index slowly falling. Consumer health has been weak, but now appears to be showing signs of improvement.

This, alongside slowing employment data, should allow the Bank of England to reduce interest rates. This removes a major impediment to a revival in sentiment for the UK’s smaller companies. History suggests that after the first rate cut, smaller companies outperform their larger peers over the next six and 12 months.

Shifting market environment

If the economic backdrop is becoming more benign for smaller companies, the market environment may also turn from a headwind to a tailwind. We see a subtle shift from a market focused on macroeconomic factors, such as the direction of interest rates and inflation, to one focused on the characteristics of individual companies. This has even been evident among the so-called ‘Magnificent Seven’, where Tesla and Apple have diverged from their peers as investors have scrutinised their performance more closely.

This is a more helpful environment for smaller companies in general, and the type of quality growth companies we favour in particular. It has long been a source of frustration for us that many of the companies in the abrdn UK Smaller Companies Growth Trust have shown strong operational performance that has not be recognised by the market. From here, characteristics such as resilience, pricing power, and balance sheet strength – the type of characteristics we value – may be rewarded by the market.

M&A activity

Companies are increasingly taking their destiny into their own hands. Some are buying back stock, reasoning that if the market will not value their business properly, they are going to back it with their own capital. Bid activity is also picking up. In particular, bids are coming in from private equity groups with cash to spare. At the margins, trade buyers and other listed vehicles are also taking an interest. Some companies have been taken out at too low a price, but it may help create support for smaller company share prices in the longer-term, particularly for the highest quality companies.

More recently, the government has also done its bit for the sector. It announced plans for the new British ISA, alongside a number of disclosure requirements for UK pension funds designed to encourage them to invest in smaller companies . There is more that could be done, but it is clear that policymakers of all political stripes are focused on reviving the UK equity market and smaller companies should be a beneficiary.

This is a stronger backdrop than has been seen for smaller companies for some time. Nevertheless, there are still pockets of fragility. It is a more difficult backdrop for companies with higher debt, weaker business models or poor pricing power. Companies are having profit warnings and finding resilient companies with good visibility of earnings is important.

UK small cap is a diverse investment class, with lots of great companies. With a tailwind from policymakers, M&A, plus a benign macroeconomic and market environment, we are more confident on the outlook for smaller companies than we have been for some time.

Companies selected for illustrative purposes only to demonstrate the investment management style described herein and not as an investment recommendation or indication of future performance.

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Issued by abrdn Fund Managers Limited, registered in England and Wales (740118) at 280 Bishopsgate, London EC2M 4AG. abrdn Investments Limited, registered in Scotland (No. 108419), 10 Queen’s Terrace, Aberdeen AB10 1XL. Both companies are authorised and regulated by the Financial Conduct Authority in the UK.

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