By Rob Morgan, Chief Investment Analyst at Charles Stanley
The UK smaller companies sector is showing tentative signs of recovery as investors increasingly search for growth opportunities outside of big US tech. Against positive expectations of falling interest rates and what looks to be a stable period in UK politics could there be further to run?
Short term market moves are unpredictable but there could be opportunities for long term investors. UK consumer and business confidence is on the up. Many smaller UK businesses offer a better way to capitalise on positive economic signals than the internationally facing larger companies that dominate the broader market.
In addition, the downward trajectory of UK interest rates, expected to begin shortly, could offer relief to more indebted businesses and make borrowing for growth more attractive.
The more stable political and economic situation following a spell of volatility could also be appealing for international investors. The UK may increasingly be viewed as an inexpensive ‘safe haven’ provided the new government’s tax and spending plans are appropriately received. Specific policies from the new government may either help or hinder individual companies and sectors, but some stability and clarity should also allow businesses to better plan for the future. The Labour party has also made supportive comments around fostering economic growth and reinvigorating the UK’s capital markets.
But the most compelling argument is one of valuation. Even within the context of an inexpensive UK market, smaller companies are cheap relative to larger ones, despite frequently being able to maintain their growth potential regardless of the economic backdrop.
What are the risks of UK smaller companies?
Smaller businesses can be less diversified or have more reliance on a narrower range of suppliers and customers than large blue chips. They can also be more susceptible to changes in sentiment because they are usually less ‘liquid’ – or easily tradable – than larger company shares, and this can lead to bigger share price moves.
Typically, smaller companies are closely tied with the performance of the domestic economy. Should this take a turn for the worse, for instance if consumer sentiment deteriorates and the important services sector faces headwinds, then smaller company shares would likely suffer. While the pressure of inflation is now easing on households and the jobs market remains resilient, this cannot be taken for granted. It is also worth noting that the UK tax regime can have an impact and, as always, is subject to change
The stealth rise in UK smaller company shares
While investor focus has remained on US markets, notably the technology-enabled giants, a meaningful rise in the value of UK smaller companies has gone largely unnoticed. In 2024 to date the average fund in the Investment Association UK Smaller Companies sector has matched the rise of the average fund in the North American sector – both have risen by around 12%.
However, some investors are starting to take an interest. According to new research we commissioned, 35% of DIY investors have increased their exposure to the FTSE 350 index of large and mid-sized companies. Meanwhile, 28% have increased their exposure to smaller companies via the Alternative Investment Market (AIM).
Past performance is not a reliable indicator of future returns. Figures are shown on a % total return, bid to bid price basis with net income reinvested; Source: FE Analytics, data to 30/06/2024
The upturn in fortunes for this part of the UK market has partly been down to corporate and private equity buyers. Increasingly, they have been capitalising on low valuations to snap up complementary businesses. This activity has helped shine a spotlight on the sector, underscore the value to be found and brighten overall sentiment.
Research carried out between 05/07/24 and 10/07/24 by Censuswide with a sample of 1007 UK ‘DIY’ investors.
