UK smaller companies are often seen as a play on the domestic UK economy, but in reality on the BlackRock Throgmorton Trust (THRG), we always have the choice to invest in more internationally-focused companies if that is where we see investment opportunities. However, at the moment we see the best prospects for long-term capital growth in the domestic market. Why?
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.
UK small caps – and domestic companies in particular – have been through their longest bear market in history1. The reasons behind this weakness have been well-rehearsed: from the sluggish UK economy, to the instability of its politics, to higher interest rates. Investors have turned away from investing in UK markets and small caps have been notably out of favour. The share price weakness has been near-universal, affecting the majority of sectors and businesses.
This has left valuations looking low on every measure – relative to earnings, relative to international peers, and relative to their own history2. For the majority of companies, the feared weakness from a more sluggish environment has not materialised, particularly among the type of low debt, high quality businesses in which BlackRock Throgmorton Trust (THRG) invests. These companies have, for the most part, continued to grow their earnings and pay dividends. It is worth noting that the yield on the FTSE Small Cap is now higher than that on the FTSE 1003.
While operational performance and earnings hold up, sentiment has remained poor, it has meant that these companies continue to get cheaper. In particular, the premium for higher quality businesses has all but disappeared.
Small cap catalysts
While we do not believe that valuation is, of itself, a catalyst for a reappraisal of the smaller companies sector, there are a number of factors coming together that appear to be prompting investors to look again at UK Smaller companies.
The interest rate environment is shifting. Inflation may not be coming down as quickly as hoped, but it is past the peak and the most recent CPI reading was 2%4, in line with the Bank of England’s target. This gives some flexibility for the central bank to cut later in the year. Bond markets are now more realistic on interest rate cuts, which is giving businesses and households greater visibility and stability. Smaller companies have tended to fare better as rates fall.
M&A activity is picking up strongly, with international corporate and private equity buyers taking a growing interest in UK companies567, A variety of buyers recognise that these companies are being mispriced by the market and are seizing the opportunity to snap them up at lower prices. Companies are buying back equities and those buybacks are helping absorb some of the flow coming out of smaller companies. While the giant buybacks from larger companies have captured the headlines, it is very much a phenomenon in smaller companies as well.
The market is ripe for reappraisal. Even a small reversal in the outflows from the sector would make a significant difference. Equally, any revival in the IPO market would reinvigorate the market and bring a new opportunity set. In the very short-term, we have started to see investors recognise the opportunities in British smaller companies. We believe this is set to continue.
