Smaller companies and Labour’s new broom.
- Ahead of the budget, small caps had been on pause.
- The Budget and subsequent Mansion House speech address some, but not all, of the concerns for small caps
- Smaller companies have been making solid progress even without these reforms.
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 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 inheritance tax 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 tide of risk warnings. The new PISCES exchange is also an interesting innovation, and could support the development of growth companies in areas such as fintech, AI, and data infrastructure.
There were disappointments too. The inheritance tax (IHT) applied on 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 unwelcome increase in costs. Businesses are endlessly adaptable, but it would be nice if they didn’t have to be.
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% in the year to 31 October. This 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 pensions administrator JTC, food producer Cranswick, internet services group 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 to spend. In theory, the consumer should be stronger, with savings rate 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 have seen their share prices high hard. Good businesses with strong balance sheets are often able to profit from the weakness of others. We have seen this with our largest holding, Morgan Sindall, which is benefiting from the bankruptcy of its closest competitor. Its strong balance sheet has allowed it to take advantage.
At the same time, M&A is strong, with the UK’s 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.
