The world has been so volatile in the last number of years that any commentary can quickly seem dated and redundant.
In recent years the world has grappled with lockdowns, Russian invasions, the end of zero rate interest policies and the risky spectre of stagflation. We have seen fundamental and profound changes, and these show no signs of abating. Nevertheless, a shifting of market focus away from the US technology sector is welcome and may sow the seeds for stronger performance from UK smaller companies.
Since 20 January 2025, when the new Trump Administration began to re-write the global economic framework, equity markets around the world have endured massive uncertainty.
Markets, even the near-term voting gauge, initially reacted with fury. Already suffering from a general lack of confidence and clarity, the immediate aftermath saw global equity markets fall, and bonds rally as investors sought safe havens. There is still uncertainty on a level we have rarely seen, uncertainty that will have profound implications for portfolio construction and returns.
The challenges faced by UK small-caps
Our positive view on the UK has proven to be incorrect, with the new government making a shaky start. However, at the margin, there are some things to be optimistic about. From a domestic stance, the government may have learnt some of the early lessons and is starting to make real changes. It is no secret the UK has been in the grip of a pervasive regulatory creep for a number of years.
Labour is making positive endeavours to change things, including planning reform and change at the head of the Competition and Markets Authority.
Outflows from UK smaller companies have remained significant through the last 12 months, with the only buyers of any note being the companies themselves through record levels of share buybacks. Merger and acquisition activity is leading to companies leaving the stock market, with (at the time of writing) 16 companies already receiving bids this calendar year.
The international nature of many UK smaller companies means there is nothing to stop firms heading for the promised sunny uplands of a US listing. Something needs to be done to make investing in the UK attractive again and recent events in the US may be starting this shift in attitude.
In the meantime, the market environment for smaller companies is tough. In many cases, we feel share prices have not adequately reflected the underlying earnings performance. Top of the leaderboard this year is pension consultancy XPS Pensions (XPS). Earnings have been upgraded a number of times this year partly reflecting the supportive background for the industry, which in the case of XPS has been amplified by a string of impressive client wins. Yet this has not yet been fully reflected in its share price.
In previous years we have noted how whole industries can change, making the uninvestible finally investible, with the most recent example of this being the construction sector, where a series of very public bankruptcies have changed the pricing dynamics.
The food producer sector has previously been one where we have struggled to get comfortable with the business risks: often small suppliers facing into an industry dominated by a small number of very large customers, poor industry discipline and often weak balance sheets with legacy pension liabilities stemming from when these firms employed significantly more people.
Overall, this is a critical juncture for investing in UK small- and mid-caps. Outflows persist, placing continued pressure on share prices and by definition on the valuation of those companies that remain listed. Government policy, particularly with regards to AIM and inheritance tax, places further distortions.
In light of these pressures, management teams are voting with their feet, either choosing to list somewhere else or delay any capital market activity, while would-be acquirers are taking advantage of the valuation anomalies the listed market is unable to seize, and purchase companies at very attractive prices.
The UK needs a period of stability, enough to make long term investors once again consider the long-term investment opportunities the UK market offers and for companies to have confidence that London is a suitable listing venue. The current global political climate may just be the catalyst that starts this process of reassessment on the long-term growth prospects for the UK small-cap market.
Roland Arnold is portfolio manager of the BlackRock Smaller Companies trust. The views expressed above should not be taken as investment advice.