Investors have been waiting for green shoots from UK smaller companies for much of the past two years. Rising interest rates, higher inflation and economic uncertainty have conspired to suppress any revival. The sector has been through the deepest and longest period of underperformance in over 40 years.
Capital at risk. The value of investments and the income from them can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested.
It is clear that low valuations on their own will not bring investors back to UK smaller companies. The sector has been cheap for some time, and has got cheaper as the operational performance from smaller companies has improved, but share prices have continue to lag. In the end, it is likely to be a confluence of factors that will bring investors back to the sector.
A stronger performance from the UK smaller companies sector since November has given some cause for optimism that sentiment could shift. In the short-term, a stabilisation in interest rates and inflation has improved confidence. Buyback activity and a revival in merger and acquisitions have also played a role.
Smaller company fund flows
However, a self-sustaining recovery has yet to appear, with flows into UK Smaller companies still weak and investors still wary. The UK Smaller Companies sector shed another £62m in January, according to the latest Investment Association data1. The causes of these weaknesses are both structural and cyclical, and there will need to be evidence that they are unwinding before smaller companies can make significant progress.
Smaller companies tend to struggle at times of rising borrowing costs, and where market sentiment is weak. This is not confined to the UK, but UK smaller companies have also had to contend with poor sentiment towards UK markets in general and a more difficult economic backdrop.
There are reasons to believe the UK economy might be at a turning point. Certainly, it isn't in the mess the rhetoric suggests. While it slipped into recession in late 2023, it was short-lived, and the economic returned to growth in January2. PMI data – a forward-looking indicator of economic strength – has also been robust3.
Household cash flows are improving as interest rates and inflation peak. Unemployment is still very low, and wage growth is ahead of inflation4. This is continuing to support consumer confidence. An interest rate cut would be helpful, but is not essential to any revival for smaller companies.
Corporate confidence revives
Corporate confidence is also improving, which is seen in growing merger and acquisition activity. There have been bids for major UK companies such as Currys and Direct Line and this is filtering down to the highest quality smaller companies. Companies increasingly have the confidence to buy their peers and build market share. This is also helped by strong balance sheets, which means companies have the cash to invest. This is putting a floor under share prices for smaller companies.
It is difficult to call a turn in the market. There is still fragility in certain sectors: it remains important to be selective. However, we believe that many of the factors that have held back UK smaller companies in recent years appear to be stabilising or reversing. There are compelling opportunities to pick up high quality companies at low valuations. As such, now might be the perfect time to consider adding BlackRock Smaller Companies Trust to your portfolio whilst taking advantage of your new tax-free ISA and pension allowance.
Sources:
1 The Investment Association - Fund statistics - January 2024
2 The Financial Times - UK economy returns to growth in January - March 2023
3 S&P Global - S&P Global Flash United Kingdom PMI - March 2024
4 The ONS - Average weekly earnings, Great Britain – February 2024
Risk warnings
Past performance is not a reliable indicator of current or future results and should not be the sole factor of consideration when selecting a product or strategy
Capital at risk. The value of investments and the income from them can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested.
Description of fund risks
Counterparty Risk: The insolvency of any institutions providing services such as safekeeping of assets or acting as counterparty to derivatives or other instruments, may expose the Fund to financial loss.
Gearing Risk: Investment strategies, such as borrowing, used by the Trust can result in even larger losses suffered when the value of the underlying investments fall.
Liquidity Risk: The Fund's investments may have low liquidity which often causes the value of these investments to be less predictable. In extreme cases, the Fund may not be able to realise the investment at the latest market price or at a price considered fair.
Smaller Company Investments: Shares in smaller companies typically trade in less volume and experience greater price variations than larger companies.
