By Mark McSherry
New research from Edinburgh investment giant Abrdn said UK smaller companies (small caps) globally are at historically cheap valuations – and UK and Europe currently offer the best value of all.
“This is despite the fact that UK smaller companies have delivered the best returns of smaller companies globally in the year-to-date (YTD), although past performance is no guarantee of the future,” said Abrdn.
“Admittedly AIM – Britain’s junior stock market – has been shaken recently by rumours of potential cuts to its tax benefits.
“However, UK smaller companies encompass not just AIM but also innovative, fast-growing firms on the main market.”
Abrdn manages and administers £506 billion of assets for clients.
Abrdn said that due to their potential for long-term returns and growth, listed smaller companies “typically trade at a premium valuation, because investors are willing to pay more for access to this potential.”
However currently their premium “is far below historic averages.”
This effectively suggests, Abrdn said, that investors “would get much better value if they buy into UK smaller companies now than they would typically have done investing in them over the past 10 years.”
Comparing the MSCI UK Small Cap Index with the MSCI UK Index — which covers large and mid caps — Abrdn found that the former is trading at a 16% premium valuation, using a 12-month forward price to earnings ratio to the end of August.
“This is significantly below the 37% average premium UK smaller companies have traded at over the past 10 years,” said Abrdn.
“Looking across the MSCI small cap indices globally, Abrdn’s analysis shows that almost all of them have valuations which are currently below their historic averages. However, the UK ties Europe as the region where valuations are lowest compared with their historic average and therefore the two are the ‘cheapest’ regions in absolute terms.”
Abrdn said low valuations belie the fact that UK smaller companies have outperformed smaller companies in other markets over the short-term.
“Looking at the past three months, the YTD, and the past year up to 30 September, the MSCI UK Small Cap Index outperformed its counterparts in the US, Europe, Asia ex-Japan, Japan and emerging markets.
“Over a 3-year and 5-year time horizon, performance has been less positive and the UK has significantly lagged – however it is encouraging to see the positive turn-around.”
Abrdn said the AIM market has “wobbled” recently following discussions around potential policy changes that could make investing in it less tax efficient.
“Yet when you look at the MSCI UK Small Cap Index – a broader definition of ‘small cap’ it has done well and outperformed the FTSE 100,” said the asset manager.
“From January 1 to 26 September, it rose 11.09% while the value of the FTSE 100 grew by 10.49%. Over the 12 months to 26 September, the difference was even greater – 20.52% vs 12.9%. Past performance is no guarantee of future returns …
“All this is supported by strong prospective earnings growth for UK smaller companies currently.
“Companies in the MSCI UK Small Cap Index are forecast to grow their earnings by 16.4% and 9.9% in 2024 and 2025 respectively. While the large and mid caps that make up the MSCI UK Index are forecast to grow earnings by much less: 5.9% and 5.7% over the same time frames …
“What’s more, separate data shows that UK small caps have historically outperformed the FTSE 100 following interest rate cuts. While this isn’t guaranteed by any stretch, it suggests that the UK’s current interest rate cutting cycle could be a potential boon for this segment of the market.
“Research by Berenberg, looking at the performance of UK small, mid and large cap stocks following UK rate cuts going back to the 1970s, shows that historically this environment has been positive for smaller companies.
“In the 12 months after an interest rate cut, the valuations of UK smaller companies have grown by 9.3% on average, it found. This compared with just 6.5% for the FTSE 100.”
Abrdn’s economists are expecting the UK base rate to fall to 3.75% by end-2025.
Abby Glennie, manager of the Abrdn UK Smaller Companies Fund and the Abrdn UK Smaller Companies Growth Trust, said: “Smaller companies have been an asset class to have exposure to over the long-term, given the attractive returns that have been generated, as well as diversification benefits when included as part of a broader portfolio.
“Holding for longer periods, such as five years, can help investors navigate volatility, but we see a particularly attractive entry point into UK smaller companies now.
“This is down to current valuations, both absolute and relative to larger companies, as well as the ongoing strength of company balance sheets and reporting from our investee companies.”
Euan Baird, director in Abrdn’s institutional team, said: “UK smaller companies have been overlooked by many investors, particularly domestic institutional investors in recent years.
“This is partly because portfolios have been reweighted to become more global, leaving little room for UK smaller companies. However arguably investors are missing out on a significant potential opportunity by not considering this area of the stock market.
“British smaller companies have attractive valuations and robust earnings growth which, coupled with the broader backdrop of recovering growth, monetary easing and improved political conditions, makes for a compelling proposition.”