This time last year, UK smaller companies looked to be on track for an exciting revival. Since then, the outlook has become more complicated. Smaller companies have inevitably been caught up in the general ‘risk off’ mood in markets. Also, while the UK economy has been showing signs of a strong recovery, investors don’t trust that it will last.

There are two key factors that can lift share price returns over the long-term: earnings growth and share price re-rating. The first is in our hands. Our matrix-driven investment process aims to uncover high quality companies that can deliver sustainable earnings growth over time. The second relies on sentiment, and is less predictable, but we see some encouraging signs.

The real case for UK small caps is the companies themselves. Earnings growth was a powerful driver of returns in 2024 and looks likely to be just as important in 2025. The UK small cap market delivered high single digit returns with no re-rating. This year, while the UK economy is forecast to deliver only 1% GDP growth, companies in our portfolio are forecast to grow their earnings by 16%.

Investors are not being asked to pay very much for that growth. Smaller company share prices have long since lost touch with the fundamentals of company performance. Even after the relative weakness of US markets since the start of the year, the UK market, and smaller companies in particular, continue to stand out as having extreme discounts to history, and discounts to other geographies.

A re-rating?

This earnings growth alone should drive the performance of smaller companies this year , but what about that elusive re-rating? While the small cap market doesn’t need it to make progress in 2025, it would be a ‘nice to have’. For this, sentiment would have to shift on the outlook for UK smaller companies.

There are positive signs. Investors appear to be warming up to UK assets once again. The FTSE 100 has had its longest winning streak in eight years and is one of only a handful of markets to be in positive territory for the year to date. Recoveries tend to follow a predictable pattern: investors move into large caps and index products first, but once they grow more comfortable with a particular region, they will start to look at small and mid cap companies, and more active management styles. We have seen this phenomenon in European markets since the start of the year, and believe it could be replicated in the UK.

UK smaller companies have been held back because they were seen as tied to the fortunes of the UK economy. This never stood much scrutiny – small caps have always offered a choice of UK and international-facing businesses and the abrdn UK Smaller Companies Growth Trust is a blend of both. Nevertheless, when some rationality returns to markets, we believe investors may conclude that UK domestic revenue streams hold more appeal, given their insulation from external pressures and uncertainty.

Interest rates coming down will also be a catalyst for UK smaller companies. It may be no coincidence that UK small and mid cap markets outperformed UK large cap over the past month, as a UK interest rate cut appeared inevitable.

Domestic UK exposure is not the ball and chain it once was. The UK economy has been stronger than expected in recent months, and – while there are uncertainties ahead – the UK consumer has been surprisingly buoyant.

Approximately 55% of the revenues from companies in our portfolio are generated domestically, so a significant portion of our portfolio has no tariff risk at all. Even where we have exposure to companies with US revenue, many are not subject to tariffs due to the nature of their business—such as services or software—or because their products are currently exempt from tariffs (e.g., Bloomsbury in books). That is not to say that there aren’t risks. If US tariffs bring about recession, it will create a tougher environment for all companies.

Managing uncertainty

A quality focus helps manage some of the uncertainties. A strong balance sheet, for example, gives companies significant flexibility. A good management team may have a keen eye for the strategic opportunities created by an economic downturn, while companies with market share and pricing power should be in a better position to weather a weaker environment.

There are also a range of other factors that could prompt a change in sentiment among investors. Measures such as adjustments to stamp duty, changes in ISA allocations towards stocks and shares, and pension reforms could all stimulate market activity. UK small and mid cap stocks are crucial for influencing UK economic growth. Equally, investors may start to pay attention to the number of private equity or trade buyers that are taking an interest in these same UK small and mid cap companies.

A new era?

We believe the last few months have witnessed the end of US exceptionalism in markets. With that in mind, investors might start to look beyond a narrow range of mega-cap technology companies, that have sucked oxygen from growth investments elsewhere. It is worth noting that the US markets have only moved back to where they were in August last year. They have lost their immediate post-election gains, but do not, by any stretch, look to be good value.

We recognise it may take time for investors to feel confident enough in stock markets to redeploy their capital and particularly towards an out-of-favour area such as UK smaller companies. But a little change could make a big difference for the sector, and we are optimistic that ultimately, investors will start to appreciate its strengths. 

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Issued by abrdn Fund Managers Limited, registered in England and Wales (740118) at 280 Bishopsgate, London EC2M 4AG, authorised and regulated by the Financial Conduct Authority in the UK.

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