Why UK small caps will continue to recover

Abby Glennie, manager of the abrdn UK Smaller Companies Growth Ord (LSE:AUSC) Trust, sits down with Sam Benstead to discuss the opportunities and risks in the UK small-cap sector. She speaks about the health of the UK economy, and which UK smaller companies are set to perform well in the current economic environment of falling interest rates.

Glennie also goes into depth on the Alternative Investment Market (AIM) and why political risks may be overblown.

This interview took place before the Budget on 30 October.

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Sam Benstead, fixed income lead, interactive investor: Hello and welcome to the latest Insider Interview. Our guest today is Abby Glennie, manager of abrdn UK Smaller Companies Growth Trust. Abby, thank you very much for coming into the studio.

Abby Glennie, manager of abrdn UK Smaller Companies Growth Trust: No, thank you for having me.

Sam Benstead: The economic environment in the UK is changing. Interest rates are falling, inflation is back around 2%. How will this new environment affect how smaller companies perform?

Abby Glennie: There's probably two sides to that, which is how the companies themselves might thrive, also the dynamics that drive equity markets often.

We believe that rates falling will be a positive for UK small caps as an asset class, particularly if you compare relative to large cap. Also we believe that should be a style benefit for us. So, falling rates should favour growth companies more over value, and we are very much focused on growth company space.

We absolutely saw both of those things work against us when rates were rising. So, I think now we're on that pathway and it feels like investors have confidence that we're on that pathway of rates coming off. And it's more about the pace of that decline of such that is the unknown. So, we would think that's a positive.

I think in terms of the companies, the UK small-cap space, absolutely. About 50% of revenue in the trust, but also just in the asset class, is generated overseas. So, about 50% is UK.

What we're seeing is more health and economic growth coming through, and I think that's a real positive. But importantly, we also are picking stocks that we think have levers for growth. So, that's what we're trying to do is invest in companies that we think are more in charge of their own destiny in that aspect. So, they have a good growth strategy, they have angles they can pool, they have new products or services or geographies. And I think we've seen that sort of economic strength start to come back. It's a real opportunity for some of our companies to thrive again.

Sam Benstead: Have you made any tweaks to the portfolio then, given this new economic backdrop?

Abby Glennie: We try and be bottom-up stock pickers, but you absolutely have to consider the macro. So, we try and do that based on how that's impacting companies. But you also have to be aware that in certain periods your macro can really dominate.

And that is where our risk tools really come in terms of controlling those factor exposures. I would say we've had higher turnover over the recent year. I think that's quite healthy at this point in the cycle.

We are at a turning point in the economic cycle, and you would expect that different companies become quality growth and momentum through that. Now, some of them absolutely will thrive throughout, and I think that's where a lot of our longer-term holdings, which are resilient businesses [with] good revenue visibility, [and] they've continue to thrive.

We've seen a lot of the Matrix, for instance, our stock screening tool, push out a lot of diverse new ideas for us, which we've acted on. But that also means that you have to exit some holdings. We're trying to find cash, I guess, from elsewhere. 

The challenge with this cycle is that the length of recovery for some sectors and some areas has been longer than anticipated. And that's really where Amanda and I have moved on from some holdings that we had.

Absolutely look, if a company is going through a shorter-term tougher period, and we can see that investment case improving, and we feel positive about the outlook, we will hold on to that.

But where that pathway of recovery gets pushed out and elongated, those tend to be the ones that Amanda and I have stepped away from.

One of the great things about the Matrix is that it doesn't know these companies. It's never met the management team and it doesn't have any emotional attachments to stocks, so it keeps you really neutral in that sell discipline.

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Sam Benstead: Can you give some examples of the sectors and companies that are struggling in this new environment?

Abby Glennie: Some of the areas that we've been a bit more cautious on recently would be some of the tech companies, which had really strong earnings growth periods during Covid, for instance, and in the years after that. It's not so much that they're struggling, but they're not growing at the rate they had, and therefore that hurts our earnings momentum, and that's a challenge for our process.

We've seen, for instance, in the recruitment space, [that] the recovery there has been slower than anticipated.

In some of the housing and construction-related names, now there's macro, which helps support the recovery of that, but I think particularly when you look at some areas, they can be [later cycle in that].

So, for instance, one thing that we do hold is Mortgage Advice Bureau (Holdings) (LSE:MAB1), which has a couple of benefits. It can be earlier cycle in that activity pick-up. It also can grow as well because it will have the confidence to add advisers and it benefits from remortgaging activity. We can see in terms of visibility, the remortgaging cycle that has to happen in the UK domestic space.

Sam Benstead: We have a new government in power now in the UK, we've got a big Budget coming up. How does this impact the investment environment in the UK and particularly smaller companies?

Abby Glennie: It's a really interesting time because the Budget is a few weeks away now, so comments can age quickly in this space.

How we feel is, we were glad to see that there was a really clear outcome on the election because I think that has allowed that government to really just move on with things. Definitely all the metric we hear about driving economic growth is a real positive and a real positive for UK small cap.

The other supportive thing we've seen lately is much more discussion and hopefully action about the awareness of what they need to do to drive a really healthy listed stock market in the UK. There's been a lot of research and papers and things about the shrinkage in UK small cap, and how costly and challenging it is for companies to list here.

We've also seen in terms of the open-ended vehicles, a really tough environment for years, and UK pension funds are really not supporting UK listed markets at the moment. It feels like the government is now behind that and taking action on that.

The real thing overhanging UK small cap at the moment is the risk around AIM [Alternative Investment Market]. There is a lot of discussion that perhaps they will make some business property relief changes in the upcoming Budget, which impacts inheritance tax.

Now, this is an area why we have, for instance, the IHT funds, our AIM holders. So, we've seen a real, what I would call a buyers' strike in AIM, over the last month or so. I don't think it's been driven by outflows, but just a lack of inflows. We really have seen AIM underperform versus the FTSE.

What I would hope from the Budget is that we don't see a change. What we really need is some clarity to remove that overhang risk. So, I think everyone will be listening with great attention on 30 October as to what they say.

The last thing is that there's a lot of evidence that Labour talk about trying to drive. For instance, I think housing is one that people hear about a lot, but you have to be aware that there are not masses of surplus of funds out there for them to be able to drive certain areas. So, I think that's the nervousness at the moment. Where are they going to find some of the capital to really do what they say they want to do?

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Sam Benstead: This AIM story is really interesting. Is that somewhere you invest, and are you seeing opportunities given the poor sentiment to the market currently?

Abby Glennie: We do invest in AIM. At the moment, the portfolio is about 26% in AIM companies and our benchmark also includes AIM. So, the benchmark that we look at is the Deutsche Bank Numis Smaller Companies plus AIM, so that is about 27% AIM. So, we're neutral in terms of weightings verses the benchmark.

On the risk versus opportunity, the challenge is that I think it's a bit of a binary event. Although there are opportunities definitely in terms of the pressure we've seen on some really great-quality AIM companies that have reported, been growing earnings really well, and beaten their expectations, their share prices have lagged, and I think that's partly because they are AIM-listed.

The challenge is that these things are never priced in. So, if we get a bad news event on the day, I think we will see a harsh reaction in AIM. I don't think we'll have big sellers on day one, these AIM IHT funds will take time to manage what will happen, and perhaps it will only impact new money into the IHT funds.

But we think our companies will be fine. We are weighted in the larger-cap companies within AIM. So, what we would expect most of them to do if AIM becomes a not-attractive place to invest anymore, [is] move to main listings and hopefully there are some easier pathways that can be created for that to happen. But, yes, I think there is a risk on the day around AIM.

Sam Benstead: Investing in UK smaller companies is seen as a high risk/high reward part of the investment world. What do you do if things are going really well or really badly in some of your positions?

Abby Glennie: I think that people look at smaller companies as the riskiest asset class often within equities. Now, I think there is absolutely volatility within the space and that's why we always encourage clients and investors to take a longer-term time horizon. So, we tend to talk about five years.

For instance, if we look at the holding period for the trust and we look at the returns volatility, there has been a good entry point and a bad entry point. But if you've taken a five-year holding view, [we've] generally always generated a positive return, and we've always generated a better return than the benchmark over that. Now, if you've got your timing the best that it could be, I think you've generated up to a 25% return per annum. So, yes, I think the holding period is a really important point in that volatility.

I think the other thing is that it depends what the investment process is. So, our quality-growth momentum investment process, the quality aspect of that is really important in terms of volatility protection. If we look over the long term, at the upside and downside capture, so how has the fund held up in difficult market environments, for instance, actually that is a period [where] sometimes we've generated our best relative performance.

So, with that quality bias, through longer-term periods, we've often protected assets in the downturn.

What do we do with stocks? So, if a stock's doing really, really well, we're not scared to add more to that. As long as the investment case still stacks up, as long as the Matrix still likes the stock, as long as when we look at valuation, it still looks palatable given everything else that's going on with the business. We will run our winners, but we will also add to those. Similarly though, we are not scared to exit a company when it's done badly.

Not all investment cases, sadly, play out the way you expect them to. So, once again, this is where the Matrix is a really useful tool for us. But, if we don't see that investment case reverting in a suitable time period, then we will move on from that and redeploy capital.

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Sam Benstead: The discount on the trust is about 12%. How does the board manage that? And is this an opportunity for investors?

Abby Glennie: The discount has been frustrating over recent periods, and we're not alone in that. If you look at the other trusts in the UK smaller company space, but also the broader investment trust space, your discounts have generally been a lot wider.

I think what you need to narrow those is - positive markets and positive performance are obviously a big benefit - but, realistically, you need buyers. If you look at flows in the open-ended space, they are good read-across. Flows have been tough into the asset class, but those are now starting to improve though. So, I would hope that we see a similar thing in the investment trust space.

Basically you need more buyers than sellers in terms of trying to narrow those discounts and the board are very aware of the discount challenge we've had. We've had an ongoing buyback over recent periods and we have bought back a lot of shares. But it has still been challenging to really narrow it much.

Sam Benstead: Finally, the question we ask all our guests, do you personally invest in the trusts?

Abby Glennie: Yes, so I own the investment trust, but also more broadly, a large part of my savings is in the products run within our team. So, across the UK, Europe and global smaller companies space. So, heavily in small cap, but reasonably geographically diversified as well.

Sam Benstead: Abby, thanks very much for coming in.

Abby Glennie: No, thank you for having me.

Sam Benstead: And that's all we've got time for. You can check out more Insider Interviews on our YouTube channel where you can like, comment and subscribe. See you next time.