Smaller company investors have been eagerly awaiting the outcome of the ‘new broom’ at no. 11 Downing Street. It was hoped that measures in the Budget and the Mansion House speech would usher in a new, more supportive era for small caps. The verdict so far is mixed, but smaller companies have been making progress without it, as signs of recovery build.

Ahead of the Budget, small caps had been on pause. The nascent bull run had been curtained by a cloud of uncertainty, particularly on the inheritance tax (IHT) treatment of AIM shares. The speculation on tax rates and reliefs was unhelpful, meaning that even for strong companies with sound fundamentals, investors held back.

A recent abrdn-sponsored report from New Financial highlighted a number of factors that could breathe life into the smaller companies sector. It suggested that small companies needed certainty on the reliefs and tax rates that apply, and perhaps new incentives, such as a lower differential rate of capital gains or dividend tax.

They also need additional demand. In this, the priority needs to be getting more money into the system rather than simply channelling money into smaller companies on the basis that a rising tide would lift all boats. The most obvious source of demand is through pensions. There is also a broader rethink of risk culture, regulation, and market infrastructure required. “Adopting a digital first approach to capital markets would help reverse this doom loop and turn it into a virtuous circle of growth and investment”, it said.

A qualified success

The Budget and subsequent Mansion House speech address some, but not all, of these concerns. The Budget preserved some IHT incentives for AIM shares, which was welcome and prompted a relief rally in the sector. There were no sweeteners such as capital gains or dividend tax relief, but investors were generally relieved at the outcome.

The Mansion House speech brought more encouraging signs. Moves to shake up regulation, and, in particular, to adopt a more balanced disclosure approach should help create a broader investing culture in the UK, rather than one where any potential long-term benefits of stock market investment are subsumed by a disproportionate tide of risk warnings. The new PISCES exchange is also an interesting innovation that could support the development of growth companies in areas such as fintech, AI, and data infrastructure.

There were disappointments too. The IHT rate for AIM assets at 20% still makes investing in the market less attractive than previously. We are confident that companies in our portfolio will be able to absorb and pass on the rise in employers’ National Insurance contributions, but it is still an increase in costs. Businesses are endlessly adaptable, but it would clearly be easier for them if they didn't have to cope with this additional cost.

Delivering a robust recovery

However, while these various initiatives have been debated, and their impact assessed, the smaller companies sector has continued, quietly, to deliver a robust recovery. Amid all the uncertainty, the FTSE Small Cap index is up 12% over one year. It has been an even better story for quality-focused investments. The share price return for the abrdn UK Smaller Companies Growth Trust is more than 30% over the year to 31 October. This is only just behind the performance of the Nasdaq over the same period, but the technology giants have garnered all the headlines.

Unlike the technology giants, small caps have managed to deliver this return amid continued gloom about their prospects, uncertainty on the regulatory backdrop, and an unfavourable global backdrop. The strength has come from companies delivering robust, predictable earnings. This includes companies such as Funds administrator JTC, food producer Cranswick, telecom services provider Gamma Communications, and ventilation group Volution.

It is still a moment for quality businesses. The environment is still tough in many sectors, with regular profit warnings among UK companies and an element of caution appearing in the outlook statements. Industrials are struggling amid weakness in key markets such as Germany. The UK retail environment is also difficult, with consumers reluctant to dip into their savings for big ticket spend. In theory, the consumer should be stronger, with savings rates at their highest level in a decade, barring the pandemic. Consumers have plenty of firepower, they just need to be persuaded to use it.

Quality businesses have the ability to pass on higher costs and tend to have more resilient earnings. Those companies that disappoint the market on earnings expectations have seen their share prices hit hard. Good businesses with strong balance sheets are often able to profit from the weakness of others. We have seen this with one of our largest holdings Morgan Sindall, which has been executing well for some time, and has received a further boost from the bankruptcy of a competitor. The business remains well-set going forward with an excellent management team, a great decentralised model and plenty of cash on the balance sheet.

At the same time, M&A is strong, with the UK markets’ cheap valuations drawing bids from international companies and private equity. Some visibility on the trajectory of interest rates is likely to help boost activity and we are also seeing companies confident enough to add bolt-on acquisitions. 

There has even been some activity in the IPO market. We participated in Applied Nutrition, a sports nutrition manufacturer that came to the market in October, with a very strong management team at the helm. We also invested in Raspberry Pi earlier this year. The hopper is slowly being refilled.

A greater focus on bringing capital to small caps from the government is welcome, and may ultimately draw more attention from investors. However, it is a slow burn. Smaller companies – and quality companies in particular - are proving they can make progress without it.

Performance 

Cumulative total returns (%)

Discrete 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.

(A) Reference Index has been the Deutsche Numis Smaller Companies plus AIM ex Investment Companies Index since 
31st December 2017 and the Deutsche Numis Smaller Companies ex Investment Companies Index prior to that date.

Important information

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.
Risk factors you should consider prior to investing:

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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