Our thoughts on the Budget and how it will impact Smaller Companies
A Growth Budget?
Deciphering a government Budget is a game of smoke and mirrors. Beforehand, forecasts are made, projections given, information leaked. Afterwards, the smoke lingers and competing narratives are projected through a Hall of Mirrors. What do we make of it as investors in UK Small & MidCap?
Although portrayed as a “Growth Budget”, the devil as always is in the detail. Indeed, while Rachel Reeves proclaimed on the airwaves that the Office of Budget Responsibility (OBR) was forecasting a boost to economic growth of 1.4% (“that’s really positive”), the small print revealed that we may have to wait a while: this “boost” to GDP reaches 1.4% by 2073-74. What’s 50 years between friends?!
If growth is expected to be pretty pedestrian, how might the Budget impact individual companies and sectors? Bond yields spiked as investors worried that increased borrowing and government expenditure could cause inflation to rise above 2% once again. This could have a knock-on effect on lending rates and put renewed pressure on companies with high levels of debt.
Another concern for equity investors is the additional cost to be borne by businesses in the form of a National Insurance increase. How will this – and the employment rights reforms – impact decisions such as hiring; wage growth; cost management?
Trying to assess things from a macro-political or macro-economic perspective is never easy; facts can be skewed by whatever narrative you want to argue. We prefer to look from the bottom-up, taking into account the views of our companies. What does this Budget mean for them?
The best companies will take the Budget in their stride
Firstly, the broad shape of the Budget was well-trailed in advance. Companies have had months to build increased tax rates into their own budgets. In addition, there has been an element of under-promise and over-deliver: employer National Insurance has been raised by 1.2%, not the 2% that was initially rumoured. Similarly, the 6.7% increase in the national living wage is in the “mid to high single digit” ballpark that most companies were expecting already. So, there is a feeling that the Budget was not quite as onerous as it might have been.
Secondly, UK Smaller Companies are adept at handling economic twists and turns. From an operational perspective, our companies have traded resiliently through Brexit, Covid, the supply chain disruptions post-Covid and the bond yield spike following Liz Truss’ ill-fated mini-budget in September 2022. A focus on Quality – particularly high margins and strong balance sheets – stands our companies in good stead (although given such a run of events, is it any wonder that investors have avoided UK stocks in recent years?).
Indeed, while increased taxes will inevitably put some downward pressure on margins, companies are likely to mitigate the impact by increasing operating efficiencies (e.g. slowing hiring or increasing automation) or possibly by nudging up prices. Companies that start from a position of strength, with high margins and strong pricing power, should fare relatively well in this environment. In contrast, those with razor-thin margins and for whom low-cost labour is the bulk of their costs may well struggle. It is worth noting that the average operating profit margin of the companies in the Montanaro UK Income Fund is 23%, almost double the FTSE 250’s 13%.
The increase in bond yields following the Budget may pose a threat to highly geared companies, if sustained. However, with a third of our companies sitting on a net cash position, they are well-placed in this regard too. While the OBR has suggested that interest rates may be ~0.25% higher than they otherwise would have been due to the Budget, this is not a material change. The direction of travel for interest rates remains downwards. Looking forward, falling cost of capital should provide a tailwind for the valuation of longer-duration, “growthier” SmallCaps.
Thirdly, the Budget pointed to some clear pockets of strategic focus. One obvious example is that the Government has proposed increasing the number of homes built in the UK as a key plank of its agenda. Housebuilders and adjacent sectors (e.g. providers of plastic piping or landscaping tiles, such as Genuit or Marshalls, respectively) stand to benefit.
Taking a step back
It is easy to get drawn into the minutiae of the potential impacts of a Budget. But, in our view, it is far wiser to try to see the wood for the trees. We look for companies that make their own luck; that are in control of their own destiny. These are companies that have become market leaders in their chosen niche and are riding their structural growth drivers over a multi-year period. They have the potential to prosper over the long run. The inevitable bumps in the road are just part of the journey. The UK SmallCap market is home to some fantastic companies in this mould. Here are just a few examples:
Bloomsbury, the book publisher, rose to global prominence almost 30 years ago with Harry Potter; now it is riding the wave of another female fantasy author: Sarah J. Maas, whose sales have more than doubled year-on-year. Teenage girls in California won’t stop reading her books because capital gains tax in the UK has gone up to 24%.
XPS Pensions is benefitting from the increasing need for advice, consulting and administration services related to pensions, which, if anything, will only have been increased by the Budget. Through superior service, focus and technology, XPS are taking share from larger rivals such as Aon, Mercer and Willis Towers Watson in the UK. The company has been successfully riding the structural growth wave in its niche, focusing on delivering great outcomes for its clients, the Budget should not derail that, if anything their expertise will be in even greater demand.
Big Yellow, a leading self-storage provider, is creating its own growth by acquiring attractive locations and obtaining planning permission for development. This is easier said than done, resulting in a highly supply-constrained market which, in turn, drives high occupancy levels and pricing power. The recent planning approval for their flagship Kensington Olympia site took over three years to accomplish, a “champagne moment” for the company.
Cranswick, a leading pork, chicken and convenience food producer, expanded its addressable market a few years ago by moving into chicken. By investing heavily in automation, it has the most modern and efficient processing site in the UK. It is this best-in-class automation that means it is well placed to outperform its competitors in the face of the cost challenges that the Budget may bring. Cranswick’s relentless focus on being a superior operator in its niche has enabled it to deliver 34 years of unbroken dividend growth.
Games Workshop, the world-class miniature wargames company behind the Warhammer fantasy world, is driving growth in the underpenetrated US market while also licensing out its highly desirable IP. The Space Marine 2 video game was released in September to huge acclaim, while they continue to be in discussions with Amazon about creating a TV series. The company is proactively building its own future and is driving its own success.
How about valuations?
A key question for investors is how much of the Budget is already baked into Smaller Companies’ share prices.
Our hunch is that UK SmallCap valuations already reflect much more than just the Budget – they are the result of years of a steady (relative) de-rating following Brexit, Covid, the return of inflation, the Ukraine war and market outflows. The asset class looks cheap relative to its own history (11% discount to long-term average P/E); to the broader market; and even compared to other major Developed SmallCap markets (the US and Europe in particular). Our favourite metric, the cycle adjusted Shiller P/E, suggests that SmallCap could deliver double-digit annual returns over the next 5 years. It has served as a useful guide in the past.
Over the long-term, SmallCap has outperformed LargeCap by more than 3% per year and we do not believe the Budget structurally impairs that dynamic. Optimistically, it feels as though the headwinds of the past three years are finally easing. Inflation is materially lower; political uncertainties have subsided; and M&A activity is picking up. SmallCap has outperformed LargeCap over the past six and twelve months, suggesting that the worst may indeed be behind us.