At 0.25%, the Bank of England’s recent interest rate cut may be small, but it is significant for the UK’s smaller companies. A drop in the cost of borrowing has historically been a trigger for a revival in the sector, improving both sentiment and operational performance. However, it’s not the only factor that could drive the sector forward and reverse the ‘risk off’ mentality that has seen small caps lag their larger peers.

After a lot of waiting, the Bank of England has finally bitten the bullet on a rate cut. The decision was marginal, but it may help build momentum for smaller companies. While it is not universally true, smaller companies tend to be seen as more vulnerable to high interest rates. Lower rates create a more favourable environment for smaller businesses to flourish.

Equally, rate cuts tend to oil the wheels of economic growth. They encourage businesses to expand, and they give consumers more money in their pockets. This is important for small companies that are often more dependent on the domestic UK economy. The UK economy was already starting to pick up, with inflation under control and better signs on employment. Rate cuts should accelerate that strength.

Nascent recovery

However, smaller companies were already starting to recover even before the rate cut. The FTSE Small Cap sector had been running neck and neck with the FTSE 100 since the start of the year but has pulled ahead over the past three months, even amid a tougher time for stock markets generally. The recovery has been broad-based, with no sector or style dominating, which suggests stability.

Valuations had become a major factor. For much of the past two years, there had been a growing gap between perception and reality for smaller companies. Many smaller companies - and certainly the ones we invest in on the abrdn UK Smaller Companies Growth Trust – had been operating with ‘business as usual’, growing their earnings and paying dividends, yet had gone unrewarded by the market.

Many smaller companies that we look at have diverse revenues, drawn from across the world, or operate in secure niches with little exposure to the ebb and flow of economic growth. They had continued to grow and flourish in spite of higher rates and economic weakness. However, they were largely overlooked by markets, leaving valuations looking cheaper and cheaper. Eventually those valuations became difficult to ignore.

Valuations are still compelling, particularly when compared to the growth on offer. Both the FTSE 100 and FTSE 250 trade on similar valuations but have materially different earnings prospects. In 2024, companies in the FTSE 100 are expected to grow their earnings by 0.6% on average. This compared to 18.9% for companies in the FTSE 250. In 2025, FTSE 100 earnings are forecast to grow by 9%, but FTSE 250 companies should deliver over 18% again.

These valuations have brought in corporate buyers and private equity interest. They are keen to snap up small companies while they are still trading at low valuations. These low valuations have also encouraged management teams to buy back their own shares. This has helped support share prices in the near-term.

Improving sentiment

Smaller companies have also been helped by improving sentiment towards the UK more broadly. Over the past few years, the sector had become the fall guy for a broader unease with the UK market generally. There are signs that with an improving economy, and greater political stability, confidence is returning to the UK market.

Recent data from Calastone showed outflows from the UK market starting to stabilise. If this persists, it will remove a significant headwind for UK smaller companies. Edward Glyn, head of global markets at Calastone, said: “The improvement is consistent with the groundswell of positive commentary surrounding the investment case for UK equities.” The Calastone data is just one of a number of surveys that show investors starting to take an interest in UK smaller companies again.

There are other factors that may influence the outlook for smaller companies. Capital market reform rumbles in the background. It is welcome that the incoming chancellor will continue with the Mansion House reforms put in place by the previous government. Rachel Reeves is aware of the need to stimulate UK capital markets and make it an attractive place to be listed. At the margins, this should help support the market.

Company strength

However, none of these factors – interest rate cuts, an improving economy, changing sentiment – necessarily alter the fortunes of the companies themselves. It just helps investors take notice when companies are doing well. Here, we have fewer concerns. The companies in our portfolio are delivering on growth and we continue to find many new opportunities. We have strong ideas in the portfolio, plus a strong subs-bench.

We have leaned into the recovery, increasing the gearing at the end of last year, having taken it down when markets were difficult. Now, we want to maximise our exposure to the opportunities that we find. The interest rate cut is certainly welcome, but it is not the only factor driving the revival of UK smaller companies today.

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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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