Key Highlights
- The Bank of England’s interest rate cut should provide a boost for smaller companies
- Lower valuations and higher earnings growth had seen M&A and buybacks pick up
- Smaller companies have been showing strength, with more drivers than just interest rates
At 0.25%, the Bank of England’s recent interest rate cut may be small, but it is significant for the UK’s smaller companies. A drop in the cost of borrowing has historically been a trigger for a revival in the sector, improving both sentiment and operational performance. However, it’s not the only factor that could drive the sector forward and reverse the ‘risk off’ mentality that has seen small caps lag their larger peers.
After a lot of waiting, the Bank of England has finally bitten the bullet on a rate cut. The decision was marginal, but it may help build momentum for smaller companies. While it is not universally true, smaller companies tend to be seen as more vulnerable to high interest rates. Lower rates create a more favourable environment for smaller businesses to flourish.
Equally, rate cuts tend to oil the wheels of economic growth. They encourage businesses to expand, and they give consumers more money in their pockets. This is important for small companies that are often more dependent on the domestic UK economy. The UK economy was already starting to pick up, with inflation under control and better signs on employment. Rate cuts should accelerate that strength.
Nascent recovery
However, smaller companies were already starting to recover even before the rate cut. The FTSE Small Cap sector had been running neck and neck with the FTSE 100 since the start of the year but has pulled ahead over the past three months, even amid a tougher time for stock markets generally. The recovery has been broad-based, with no sector or style dominating, which suggests stability.
Valuations had become a major factor. For much of the past two years, there had been a growing gap between perception and reality for smaller companies. Many smaller companies - and certainly the ones we invest in on the abrdn UK Smaller Companies Growth Trust – had been operating with ‘business as usual’, growing their earnings and paying dividends, yet had gone unrewarded by the market.
Many smaller companies that we look at have diverse revenues, drawn from across the world, or operate in secure niches with little exposure to the ebb and flow of economic growth. They had continued to grow and flourish in spite of higher rates and economic weakness. However, they were largely overlooked by markets, leaving valuations looking cheaper and cheaper. Eventually those valuations became difficult to ignore.
Valuations are still compelling, particularly when compared to the growth on offer. Both the FTSE 100 and FTSE 250 trade on similar valuations but have materially different earnings prospects. In 2024, companies in the FTSE 100 are expected to grow their earnings by 0.6% on average. This compared to 18.9% for companies in the FTSE 250. In 2025, FTSE 100 earnings are forecast to grow by 9%, but FTSE 250 companies should deliver over 18% again.
These valuations have brought in corporate buyers and private equity interest. They are keen to snap up small companies while they are still trading at low valuations. These low valuations have also encouraged management teams to buy back their own shares. This has helped support share prices in the near-term.
Improving sentiment
Smaller companies have also been helped by improving sentiment towards the UK more broadly. Over the past few years, the sector had become the fall guy for a broader unease with the UK market generally. There are signs that with an improving economy, and greater political stability, confidence is returning to the UK market.
Recent data from Calastone showed outflows from the UK market starting to stabilise. If this persists, it will remove a significant headwind for UK smaller companies. Edward Glyn, head of global markets at Calastone, said: “The improvement is consistent with the groundswell of positive commentary surrounding the investment case for UK equities.” The Calastone data is just one of a number of surveys that show investors starting to take an interest in UK smaller companies again.
There are other factors that may influence the outlook for smaller companies. Capital market reform rumbles in the background. It is welcome that the incoming chancellor will continue with the Mansion House reforms put in place by the previous government. Rachel Reeves is aware of the need to stimulate UK capital markets and make it an attractive place to be listed. At the margins, this should help support the market.
Company strength
However, none of these factors – interest rate cuts, an improving economy, changing sentiment – necessarily alter the fortunes of the companies themselves. It just helps investors take notice when companies are doing well. Here, we have fewer concerns. The companies in our portfolio are delivering on growth and we continue to find many new opportunities. We have strong ideas in the portfolio, plus a strong subs-bench.
We have leaned into the recovery, increasing the gearing at the end of last year, having taken it down when markets were difficult. Now, we want to maximise our exposure to the opportunities that we find. The interest rate cut is certainly welcome, but it is not the only factor driving the revival of UK smaller companies today.
Important information
Risk factors you should consider prior to investing:
- The value of investments, and the income from them, can go down as well as up and investors may get back less than the amount invested.
- Past performance is not a guide to future results.
- Investment in the Company may not be appropriate for investors who plan to withdraw their money within 5 years.
- There is no guarantee that the market price of the Company’s shares will fully reflect their underlying Net Asset Value.
- As with all stock exchange investments the value of the Trust shares purchased will immediately fall by the difference between the buying and selling prices, the bid-offer spread. If trading volumes fall, the bid-offer spread can widen.
- The Company may borrow to finance further investment (gearing). The use of gearing is likely to lead to volatility in the Net Asset
- Value (NAV) meaning that any movement in the value of the company’s assets will result in a magnified movement in the NAV.
- The Company may accumulate investment positions which represent more than normal trading volumes which may make it difficult to realise investments and may lead to volatility in the market price of the Company’s shares.
- Yields are estimated figures and may fluctuate, there are no guarantees that future dividends will match or exceed historic dividends and certain investors may be subject to further tax on dividends.
- The Company may charge expenses to capital which may erode the capital value of the investment.
- The Alternative Investment Market (AIM) is a flexible, international market that offers small and growing companies the benefits of trading on a world-class public market within a regulatory environment designed specifically for them. AIM is owned and operated by the London Stock Exchange. Companies that trade on AIM may be harder to buy and sell than larger companies and their share prices may move up and down very sharply because they have lower trading volumes and also because of the nature of the companies themselves. In times of economic difficulty, companies listed on AIM could fail altogether and you could lose all your money.
- The Company invests in smaller companies which are likely to carry a higher degree of risk than larger companies.
- Specialist funds which invest in small markets or sectors of industry are likely to be more volatile than more diversified trusts.
Other important information:
Issued by abrdn Fund Managers Limited, registered in England and Wales (740118) at 280 Bishopsgate, London EC2M 4AG, authorised and regulated by the Financial Conduct Authority in the UK.
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