D:Ream’s Things Can Only Get Better became the unofficial anthem of Labour’s General Election victory in 1997. Not so this time. The group’s members banned its use on the 2024 campaign trail, insisting music and politics should not be mixed[1].
But, as he outlines in this analysis, Eustace Santa Barbara, co-manager of the IFSL Marlborough Special Situations fund, has been wondering whether perhaps the tune could instead be deployed to champion the cause of UK smaller companies?
The past few years have been challenging for businesses at the lower end of the market-cap spectrum, and investors might well appreciate a suitable ode to optimism.
The question is whether they would be singing more in hope than expectation. Let me explain why I feel the latter is far more justified – and why a long-undervalued market that remains home to a range of opportunities could at last hit the right note, particularly in light of recent volatility elsewhere.
Interest rate cuts
Central banks have finally started to cut interest rates again. The Swiss National Bank led the way in March, followed by the Bank of Canada and, more notably, the European Central Bank. There is a very strong chance that the Bank of England will follow suit soon.
This should mark the beginning of the end of a period during which unusually high saving rates have significantly defined the competition for capital. The allure of High Street banks and government bonds is likely to diminish as interest rates come down again.
In turn, this should compel investors to look further afield. Having been unloved for years, UK smaller companies deserve attention – not least given the wealth of evidence underlining the long-term outperformance of small-cap and mid-cap stocks.
Proven resilience
Just as rate reductions should work in their favour, many UK smaller companies may have learnt a valuable lesson from the higher-rate environment that has prevailed since the COVID-19 pandemic. In essence, it has taught them how to survive and thrive in extremis.
These businesses have felt the full force of inflation. They have faced rising costs for energy, employment, logistics and pretty much every other facet of their operations. They have cut their cloth accordingly – and now they are emerging on the other side of the maelstrom.
With inflationary pressures easing, we could see earnings growth coming through in earnest. In addition, if inflationary pressures return or even somehow intensify, we now know many of these companies understand how to manage their balance sheets.
Faith in themselves
The UK equity market as a whole has seen high levels of share buybacks in recent months. Almost half of all listed companies are at present engaged in programmes to purchase their own shares.
There is a school of thought that contends this type of activity reveals an organisation that simply has nothing better to do with its capital. I wholeheartedly disagree with that interpretation.
My view is that these businesses have surplus cash, recognise they are undervalued and fully grasp the appeal of investing in themselves. In other words, they are doing this not because they have nothing better to do with their capital but because they firmly believe buybacks represent an excellent use of their resources.
The status quo
I mentioned earlier the long-term outperformance of small-cap and mid-cap stocks. Although the past might not be an irrefutable guide to the future, the fact is that smaller companies have consistently grown their earnings per share more rapidly than their large-cap counterparts[2].
There is nothing to indicate this trend has been derailed. UK smaller companies have suffered a substantial derating – in part because larger-cap businesses have of late enjoyed more stability in terms of earnings per share – but this does not mean they will fail to maintain their outperformance in the long run.
Equally, there is nothing in the wider economic or political landscape to imply smaller companies have lost their long-term edge. If anything, the outcome of the General Election may have helped their cause by supplying what many investors are likely to perceive as a much-needed “reset”.
A final note
Although broad-brush perceptions of businesses at the opposing end of the market-cap spectrum have begun to change during the market falls of the past few days, UK smaller companies are not yet back in vogue. They are certainly not a focus of investor euphoria, which can impact markets in relatively short order.
After several years of headwinds, though, sentiment does appear to be shifting, and a clearly positive trajectory may be in the offing. This could translate into solid growth and attractive returns over an extended timeframe.
Maybe music and investing, like music and politics, should not be mixed. Nonetheless, it seems increasingly reasonable to suggest – with due apologies to Yazz and the Plastic Population – that the only way is up.
Eustace Santa Barbara is co-manager of the IFSL Marlborough Special Situations fund.
[1] See, for example, Guardian: “‘Never again’: D:Ream ban Labour from using Things Can Only Get Better”, June 1 2024 – https://www.theguardian.com/politics/article/2024/jun/01/things-can-only-get-better-group-ban-labour-from-using-song.
[2] See, for example, Deutsche Numis: “Smaller Companies Index” – https://dbnumis.com/equities/deutsche-numis-indices#:~:text=Over%201955%2D2023%20the%20Deutsche,larger%20companies%20by%202.9%25%20p.a.
