It’s been a hard slog for UK smaller companies over the past few years. A combination of declining asset values and net redemptions undermined the performance of open-ended UK smaller company funds, while the FTSE Small Cap UK index declined by around 35 per cent from September 2021 through to last October. Admittedly, UK small caps and mid-tier stocks still managed to outperform the overall market in 2023 and their fortunes have improved markedly since their last trough.
Anyone banking on a return to significant net inflows into this corner of the market would have paid close attention to this week’s inflation figures. That’s because companies at the lower end of the food chain suffer disproportionately from prolonged bouts of inflation and the rate hikes that come in their wake. The burden of higher input and labour costs falls heavily on these companies, while debt becomes more expensive to service. And although the headline inflation rate grabs the headlines, it is concerning that UK wage growth has strengthened even as the UK unemployment rate has edged up.
It could be argued that valuation anomalies among well-capitalised UK small caps will become more apparent once it is clear that the rate cycle has peaked. Despite the post-October rally, many of the minnows still trade at a sizeable global valuation discount, as opposed to the traditional premiums they command over their blue-chip counterparts.