Abby Glennie, deputy head of smaller companies, abrdn considers that despite the challenges, the outlook for small caps is positive.
If you look at UK small caps over 25 years, earnings power is the real driver, and we believe earnings are really healthy.
Times of dislocation like this are a chance for strong companies to get stronger, while the weak are weakened. Looking back over the last two years since the start of the pandemic, we saw that happening. Challenges can provide opportunities for our businesses. If we go into an environment with scarcer growth, growth becomes more valuable, so if we have identified the businesses that are still growing, despite headwinds, they become more valuable in a stock multiple sense. There are certainly more challenges ahead and that’s where our process does well. We don’t fear a tougher environment, but the rotation to get there can be bumpy.
Today, we’re facing three macro challenges, interest rates, inflation and supply-chain logistics. Our portfolios are invested in companies with strong balance sheets and low debt levels, where higher interest rates will be very manageable. Inflation wise, we’ve tried to identify companies that are industry leaders with pricing power, who can pass on that inflation better than their peers. As for supply-chain logistics, often we’re invested in areas that are not impacted, such as digital services, financial services and media – so goods are not being shipped back and forth across the world. Where we do have exposure to such challenges, it’s in businesses that are navigating the situation well.
We believe growth will start to dip as we enter the second half of the year. This is why we would recommend staying focused on companies that have a long-term structural growth trend, where management is driving growth rather than macro factors. Although our companies are UK-based, they’re achieving good revenue from overseas and lots of international growth. These are also businesses with many levers to pull to drive growth, such as additional products or services.
We often won’t be the first to buy a stock recovering from a tougher period. We want to see periods of good earnings and see that it’s sustainable. We aim to buy and hold when we’re confident that momentum of growth and earnings upgrades will be sustained.
Overall, valuations are attractive in UK, and often in our portfolio half the revenue is generated overseas. Brexit has not really negatively impacted our companies; it has passed quite smoothly. Many of our companies are not too dependent on the UK economy. There will always be a place in the portfolio for quality domestic names though, which even during lacklustre UK economic times, drive growth, operational improvements and margin progress, led by excellent management teams.
Yes, there are challenges ahead, but we’re very comfortable with our portfolios because of the earnings resilience they continue to demonstrate. We also remain confident on the medium-term view.