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Investors have turned away from UK smaller companies since the start of 2022. Predicting a turning point is tough, says the Team behind the BlackRock Smaller Companies Trust, but there are more optimistic signs.
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Sentiment has turned against UK smaller companies over the past 12 months and hasn’t revived even in the face of better economic data and strong earnings.1 Many smaller companies have enhanced their competitive position, strengthened their balance sheets and continued to generate volume growth in sales, but this has not been reflected in share prices. What might trigger a wider reappraisal of higher quality smaller companies?
UK smaller companies have struggled from the perception that they are more exposed to the lacklustre UK economy, unlike their more internationally-focused large cap peers. This isn’t strictly true – many UK small caps have overseas earnings.
This isn’t unusual. Smaller companies tend to underperform in periods of heightened volatility and markets where investors are less inclined to take risks. There are higher risks associated with smaller companies investing, which tend to come to the fore during tough periods. Smaller companies tend to be focused on a single product area and operate in specific niches of the economy. This can leave them vulnerable if business dries up.
However, we would suggest that it also means some businesses are well-insulated from the difficulties of the wider economy. If they make mission critical parts for a specific industry, they may prove more resilient than the wider market. Equally, while there are indebted smaller companies, this is by no means the norm and we actively target companies with strong balance sheets in the trust.
The companies we hold have generally seen robust operational performance, but this hasn’t affected the way they are perceived by the market. Investors have continued to group all smaller companies together, assuming that all will be equally affected by the economic slowdown and rising interest rates.
A turning point
What might change this viewpoint? When we look at previous cycles, it is difficult to point to a single factor that has galvanised smaller company performance. The sector saw declines between January and September 2014. Performance turned around in October 2014.2[1] Even with hindsight, the catalyst is difficult to pinpoint.
July 2016 kicked off another significant rally in smaller companies. In theory, the market should have been digesting the impact of the recent Brexit vote, with all the associated uncertainty. In reality, smaller companies had anticipated the outcome of the vote and sold off stock beforehand. Investors returned to the sector once the vote was clear. Similarly, during the pandemic, the smaller companies index3 turned in February 2020, long before a vaccine became a possibility or central banks had stepped in to shore up the economy.
As such, predicting the turning point in a market is an uncertain and ultimately fruitless pursuit. At some point, investors have enough confidence to return to the market, or valuations are sufficiently cheap that they see the downside as limited. However, the exact moment when that occurs is tough to identify, even after the event.
Cause for optimism?
Nevertheless, there are a number of factors that suggest a more optimistic outlook. The first is that corporate buyers are taking an increased interest in UK smaller companies. Merger and acquisition activity has picked up through the course of the year and spiked in recent months42with bids for a number of companies in the portfolio, including Ideagen and Clipper Logistics. Private equity investors have also started to deploy their substantial cash piles and are hunting in the UK smaller companies sector.5 This suggests that they see value in this part of the market.
It is also the case that the UK economy appears to be stabilising. The IMF now expects the UK economy to avoid recession in 20233and has upgraded its growth expectations from 0.3% to 0.4%.6 While inflation and higher interest rates remain a risk, the economic outlook is notably more optimistic than at the start of the year.
Then there are the companies themselves. The operational performance of companies in the portfolio continues to be relatively strong as at 31st May 2023, and many have proved themselves resilient in the face of a more challenging environment. Eventually, the mismatch between operational performance and share price performance should be recognised by investors.
The turning point for sentiment could be tomorrow, or it could be next year. However, a confluence of factors give some cause for optimism after a difficult year.
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Sources:
[1] https://www.ftadviser.com/investments/2023/08/08/small-cap-investors-can-find-opportunities-in-the-current-difficulty/#:~:text=of%20the%20storm.-,Showing%20resilience,-Resilience%C2%A0is%20the – FT Adviser, Small-cap investors can find opportunities in the current difficulty – 08/08/23
2https://www.marketwatch.com/investing/index/smx/charts?countrycode=uk&mod=mw_quote_tab – MarketWatch 10yr – 14/08/23
3https://www.marketwatch.com/investing/index/smx/charts?countrycode=uk&mod=mw_quote_tab – MarketWatch 5yr – 14/08/23
5 https://www.ft.com/content/d60d6866-920d-4617-a693-0f73b3f24eea - Private equity interest in UK plc – 21/04/23
6 https://www.bbc.co.uk/news/business-65669399 - IMF expects UK economy to avoid recession – 23/5/23
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