By Euan Baird

UK smaller companies (small caps) have had a torrid decade. They’ve been battered on all sides by shrinking demand from their natural investor base (UK pension funds), by increasing regulation, and by the growth in private markets. The latter has led to a tricky situation whereby the pool of smaller companies looking to list has been shrinking at the same time as many listed smaller companies have been choosing to go private.

Yet another straw was heaped on the sector’s back in the recent Budget with the watering down of the inheritance tax relief investors have benefitted from when buying companies listed on AIM (Britain’s junior stock market) from 100% to 50%.

The lack of support for UK small caps (or acknowledgement of their importance) is surprising. Not only do they add a huge amount to the domestic economy, they also offer compelling opportunities for investors – both retail and institutional – over the long-term, despite recent challenges.

A recent report by think tank New Financial, sponsored by abrdn, found that UK small caps are much more evenly distributed across the country than large caps – with the latter tending to be clustered in London and the South East. By contrast, small caps generate wealth, growth and jobs across almost every corner of the country – including in Scotland. And of course, the smaller companies of today will hopefully grow into the large companies of tomorrow.

What’s more, over the long-term, UK small caps have delivered well for investors.

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The New Financial report found that over 25 years the annualised total return of UK listed smaller companies (including AIM) has been 7.4%. This is in line with the S&P 500 (an index of America’s largest companies) – and nearly 50% higher than the wider UK market. Of course, investors should expect more pronounced bumps along the way with small caps – the past few years providing a case in point.

But while past performance is no guide to the future, the long-term numbers are thought provoking. What’s more, despite pain over the medium-term, in more recent times performance of UK smaller companies has been strengthening once again.

The challenging period UK small caps have faced also mean valuations are now looking very attractive.

And while recent policy changes could well negatively impact AIM, it’s important to remember that the small caps universe encapsulates not just AIM but also fast-growing companies on the main market. We see various reasons why the stars may be aligning for the wider UK small caps universe.

Firstly, the outlook for earnings growth is strong. 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, according to data gathered by the index provider. By contrast, 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. Forecasts are no guarantee, but again, it is food for thought.

Secondly, interest rate cuts by the Bank of England are likely to benefit UK small caps in particular.

Research by Berenberg, looking at the performance of UK small, mid and large cap stocks following UK rate cuts going back to the 1970s, found that small caps have historically outperformed the FTSE 100 following a Bank of England decision to trim rates. 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. Our abrdn economists are expecting the UK base rate to fall to 3.75% by the end of 2025.

Numbers aside, the UK’s current political backdrop matters too. Following a period of instability, there’s a new government in place, which has stated its mission to create a stable and pro-investment backdrop that could support business growth. Debate about the impact of the Budget aside, this is significant.

All this supports our view at abrdn that investors should pay attention to UK smaller companies and that they should be included in the Mansion House Compact.

In this compact, pension funds agreed to increase their investments in private markets – specifically areas such as private equity and venture capital.

The idea behind this was to support fast-growing UK companies. It seems only natural that this should be extended to include the fast-growing UK companies who have chosen to list here too. Such a move would mean that hard-working individuals would have access to the innovation and growth that UK small caps can provide through their pensions – whether they choose to hold them directly or not.

After a decade of letting UK small caps be battered, it’s time we consider protecting this important, valuable part of our economy.

Euan Baird is a director at abrdn