Equity Markets

During the year under review, markets proved healthier after a challenging two years. The top-down pressure of inflation came under control in the UK and other regions although, relative to expectations, it is worth noting that interest rates have remained higher for longer.

The UK stock market, as represented by the FTSE All-Share Index, performed strongly over the period, with a total return of 13.0%. The FTSE 100 Index's total return of 12.8% underperformed the FTSE 250 Index, the latter of which generated a total return of 13.9%. The mid cap universe was therefore the best performing group within the UK, outperforming the reference index. The FTSE AIM Index was the laggard, delivering just a 3.4% return. Investors continued to remain cautious about the UK economic picture, however the GDP data was somewhat reassuring and, relative to other major economies in Europe, the UK held up well.

The only real interruption to the performance of the UK market was during September and October 2023. However, the sharp rebound from the October lows has delivered a fairly smooth positive return pathway since then. UK consumer spending has improved given that inflation has receded from its peak and wage growth remains positive. However, many households continue to have the burden of higher mortgage rates or rental costs. The domestic labour market has remained resilient, with employment levels high, and good job availability across a number of sectors.

The period was dominated by the inflation and interest rate picture, with inflation subsiding steadily over the period, with some visible steps down in areas such as energy prices and food. Along with other major economies such as the US, interest rates in the UK have remained at higher levels for longer than many economists projected.

Geopolitical tensions remained an ongoing theme during the period; the continuation of the war in Ukraine, the heightened conflict in Israel since October, as well as ongoing issues surrounding relations between China and the West. As we move through the second half of 2024, the outlook is impacted by the various major elections globally, with well over half of the world's population expected to be going to the polls during 2024.

Economists and strategists have noticeably turned more positive on both the UK and small and mid cap sectors through the final quarter of the financial year. Attractive valuations have been a key aspect of their investment case, combined with strong resilience in earnings across company reporting. It should not be forgotten that, even in the smaller companies space, around half the revenue of the reference index is generated overseas. With allocations to the UK and to smaller companies having shrunk over the years, particularly from UK pension funds, that series of outflows has stabilised and is showing tentative signs of reversal. With many starting positions at all-time lows, the more positive view on the asset class could help to drive markets higher.

Mergers and Acquisitions ("M&A") have continued to be a strong feature of UK markets, not just in the smaller companies sector. As the period progressed, we saw an increased proportion of the bids being for FTSE 250 and FTSE 100 companies.

One final point to highlight is the increasing pressure to introduce changes to stimulate the market, whether it be through stamp duty changes, lower costs of listing, lighter regulation, or more control over asset class allocations. We are confident these voices are now being heard, but we will have to wait and see what is implemented and the time horizon of these policies.

Performance

Overall through the year, the net asset value ("NAV") grew by 18.1% on a total return basis, outperforming the reference index total return of 10.0%.

Discreet performance (%)

Source: Workspace Datastream, total returns. The percentage growth figures above are calculated over periods on a mid to mid basis. NAV total returns are on a cum-income basis.
Past performance is not a guide to future results.

The more stable backdrop we have been waiting for did materialise this year and the focus of the markets reverted to stock specifics and reporting, rather than being dominated by top-down factors. The consistency of outperformance has been one of the most pleasing aspects for us, as portfolio managers, this year; the Company outperforming the reference index in 9 of the 12 months (only July 2023, Nov 2023 and April 2024 delivering relative underperformance).

The style factors driving markets, such as either growth stocks or value stocks being in favour, has been more settled this period. Value outperformed growth in the first half of the period, but value and growth both delivered similar returns in the market in the second half. We would characterise style factors as a slight headwind to our strategy during the period, but neutralising as we finished the year. Performance has predominantly been driven by stock specifics, companies reporting strong trading and earnings upgrades, with share prices responding appropriately, which is a distinct improvement on the situation over the last couple of years. Attribution and style analysis show that the outperformance has been driven by stock selection, rather than our style of Quality, Growth & Momentum being in favour.

The style factors driving markets, such as either growth stocks or value stocks being in favour, has been more settled this period. Value outperformed growth in the first half of the period, but value and growth both delivered similar returns in the market in the second half. We would characterise style factors as a slight headwind to our strategy during the period, but neutralising as we finished the year. Performance has predominantly been driven by stock specifics, companies reporting strong trading and earnings upgrades, with share prices responding appropriately, which is a distinct improvement on the situation over the last couple of years. Attribution and style analysis show that the outperformance has been driven by stock selection, rather than our style of Quality, Growth & Momentum being in favour.

Whilst we saw four successful bids for companies in the portfolio during the year, all at attractive premiums, this has not been the main driver of performance. These companies were Ergomed, Smart Metering Systems, Mattioli Woods, and Spirent. Overall, those four companies contributed 198 bps of relative performance during the year.

The five leading positive contributors to relative performance during the year were as follows:

Dealing and Activity

Portfolio turnover was around 28%, which is higher than has been the case in recent years. This is reflective of where we are in the cycle and changing fortunes of companies. Over the year, we added 13 new positions, and exited 18 holdings. We took part in one IPO, Raspberry Pi.

Of the 18 holdings exited over the period, four were companies which were subject to takeover activity: Spirent, Mattioli Woods, Smart Metering Systems and Ergomed. Elsewhere, many of our exits were characterised by businesses which were experiencing cyclical slowdowns and the recovery had become protracted and with limited visibility. These included FDM, Impax, Marshalls, Focusrite, GB Group, Team 17, Kainos, Henry Boot, Future, Motorpoint, Safestore, Serica, XP Power and Watches of Switzerland.

Notable top ups during the year include Tatton Asset Management which has grown assets significantly, and Alpha Group (previously called Alpha FX) where its expansion into alternative banking solutions has been executed well. We also topped up AJ Bell which has been showing strong trading and growth, Volution which has proved resilient through volatile end markets, Diploma which has shown consistent organic and acquisitive growth, and lastly Paragon Banking where we believe credit quality and market position will deliver growth through tougher macro periods.

Gearing

The level of gearing (net of cash) at 30 June 2024 was 5.8% (2023: 2.5%). Given our improving outlook, we increased the gearing during the year and are now fully drawn on the £40 million loan facility. We continue to hold cash in the portfolio to ensure we can participate in market opportunities and are not liquidity constrained.

Revenue Account

Dividend income generated by the portfolio (excluding capital receipts) decreased by 9.8% over the year, with the main impact being the effect on the portfolio of share buy backs undertaken during the year - dividend income stated on a pence per share basis was marginally higher than last year. Interest rates remaining high also meant that the Company received £887,000 in interest income during the year.

The dividend outlook for the Company, seen through its income generation from the underlying holdings, has remained strong. Both the resilience of earnings, aided by business models and by solid trading, as well as the growth being exhibited, has helped drive the Revenue Account strength. The ability of companies to provide dividend returns to shareholders has been supported by balance sheet strength, a focus of our investment process. Meanwhile, we also see dividend strength as a reassurance of the confidence of underlying management teams.

Outlook

We wrote last year about the overhang of the market waiting for a recession which didn't really materialise. Since the market turn in October 2023, UK stock markets have been buoyant and consistent in delivery. We believe a driver of that turn was the awareness of how cheaply valued UK equities were, relative to international peers, their own history, and their earnings prospects. These points remain true as we go through the second half of 2024 and should continue to support rising markets.

What other catalysts lie ahead for UK markets? The domestic economic data has continued to turn more positive, both across business and consumer aspects. We expect to see interest rates come down, and history would suggest this to be positive, not just for absolute market levels, but in particular for small cap relative to large cap. The number of elections might act as a short-term market overhang, but outcome dependent this could also drive markets further onwards once the results are known. In the UK, the new Labour government has made a point of highlighting its awareness of the need to stimulate the economy. However, it is too early to predict whether the government or any regulatory body can successfully enact meaningful changes that will actually stimulate UK markets, something we would very much support and have been active in sharing views on.

Markets tend to anticipate improvements, and turning points in the past have been when the outlook is often close to being at its most pessimistic. The first half of the period was in that category; inflation was persisting, interest rates remained high, and the consumer squeeze was ongoing. A combination of that environment easing and improving, as well as the market looking towards the future, has helped to drive this turn in markets. Smaller companies will always be an asset class with relatively high volatility, but we believe the current time is an attractive entry point for new capital, where investors are able to take a longer-term investment horizon.

Despite strong absolute and relative performance during this reporting period, the Company's discount to NAV remains stubbornly wide. UK smaller companies is not alone as an asset class in experiencing this. Whilst we have seen a growing interest in the asset class in recent months, we feel the inflow of money has yet to be seen. This can be evidenced through open ended funds flow data which remains lacklustre. Discounts are narrowed by demand, so we would hope this can be seen during the current 2024/25 financial year given the brighter outlook.

Read the full Annual Financial report here.

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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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