Given the hundreds of stock market announcements issued every day by UK-listed companies, it’s very easy to narrow your focus either to just the shares you own or the big household names in order to keep track of what’s going on. However, smaller companies can often be the ‘canaries in the coal mine’ of trouble ahead because changes in the economy tend to impact them much quicker than they do big companies. This is especially important when tailwinds like low interest rates and cheap money are replaced by headwinds in the form of high rates, high labour costs and high energy costs, which is where we are today and which is why we are seeing a growing number of profit warnings.

SMALL AND GETTING SMALLER

Looking at the US market, Bloomberg commentator John Authers says there are signs of ‘something amiss’ in the land of small caps. ‘They are far more exposed to rising interest rates than larger companies, and the gulf in their performance has now grown quite dramatic. The Russell 2000 index of smaller companies has just dropped back below its level from the eve of the pandemic, essentially giving up all its gains since the dawn of the decade.’ Interestingly, Russell’s index of the top 50 small stocks by market cap is still up almost 50% over that period meaning it is the smaller companies which are losing ground.

Authers puts this underperformance down to the ease with which bigger companies can access affordable credit compared to smaller companies, who are more likely to experience cash-flow difficulties in the first place. While most large-cap US – and for that matter European – companies began locking in attractive long-term rates on their debt as soon as central banks started tightening, many smaller companies didn’t have that luxury. As a result, smaller companies here and in the US fall a steep refinancing ‘wall’ with up to 80% of their loans and bonds coming due in the next five years according to Societie Generale strategist Andrew Lapthorne.

OPERATING AT A LOSS

Another problem for smaller companies is profitability. SocGen’s Lapthorne estimates more than 30% of Russell 2000 companies are loss-making compared with just over 5% of European small caps, meaning they have to borrow money to fund their existence. Scott Glasser, chief investment officer of Clearbridge Investments, part of US mutual fund group Franklin Templeton, believes up to 40% of Russell 2000 companies may be unprofitable. This didn’t matter overly when interest rates were near zero, but according to the Federal Reserve’s latest survey of chief loan officers the proportion of banks tightening their standards for commercial loans rather than loosing them is now 50%, similar to levels seen during the pandemic and the global financial crisis in 2008. Even among those firm that are ‘profitable’, many don’t generate positive free cash flow, which is what enables them to pay the bills, invest in their business, reduce debt and pay shareholders an income. There is an old market saying which bears repeating: cash is fact, the rest is opinion, which means profits are an accounting norm and what really matters when running or indeed investing in a business is how much cash it generates.

ANALYSING PROFIT WARNINGS

According to consulting group EY Parthenon, which has been tracking profit warnings from UK-registered companies every quarter since 1999, the number of warnings in the third quarter was 12% lower than in the same period last year but still 18% above the seasonal average. As well as logging the number of profit warnings, the firm keeps a record of the reasons for the warnings which gives it a powerful insight into the state of UK plc and the overall economy. As its latest survey, entitled Running Out of Road?, states: ‘The pace of warnings has begun to fall as cost and supply pressures ease, but in Q3 2023 we saw rising interest rates take over as the main driver of warnings, with the highest percentage of companies citing the impact of worsening credit conditions since the height of the Global Financial Crisis in 2008’. The survey goes on to say: ‘We expect the pace of warnings to remain high whilst the impact of interest rates continues to feed through to the wider economy and whilst it remains difficult to forecast in this testing and volatile economy. Confidence can drain very quickly in this environment; therefore, it is vital that companies address issues promptly and keep stakeholders informed.’

By far the largest number of warnings last quarter came from AIM-, FTSE Small Cap- and FTSE 250-listed companies, demonstrating how vulnerable small- and mid-sized companies are compared with their bigger competitors, and how weakness in the UK economy is affecting them faster and to a greater extent than globally exposed companies which make up the bulk of the FTSE 100 index. By sector, the highest number of warnings came from industrial support services companies, followed by household goods and home construction, and software and computer services. Meanwhile, the sectors with the highest percentage of companies warning were household goods and home construction, finance and credit services and food producers.

A SEA OF RED FLAGS

The latest Red Flag Report from business advisory and insolvency firm Begbies Traynor (BEG:AIM) also makes grim reading, with the number of UK companies described as in ‘critical’ financial distress rising by 25% between the second and third quarters. Over 37,700 firms are now in critical distress, while in total nearly 480,000 businesses across the UK are in ‘significant’ financial distress, 9% more than in the second quarter of this year. While consumer-related firms like retailers have seen a sharp increase in critical financial distress, ‘pressures are now clearly being seen beyond consumer-facing sectors and are becoming widespread, particularly within the construction and property sectors’ says the report.

No fewer than 18 of the 22 sectors covered saw a double-digit rise in companies in critical financial distress from the second quarter to the third quarter, with construction seeing a 46% jump and real estate and property services experiencing a 38% increase. ‘With many UK companies accustomed to years of near zero interest rates and access to government-backed Covid support loans, the new world of elevated interest rates will continue to push many businesses the very edge of failure’, warns the report.

EXAMPLES FROM THE MEDIA SECTOR

One sector where it really pays to keep an eye on smaller companies for clues to broader trends is media and advertising, as marketing is typically one of the first things customers will cut if they are feeling the strain financially. In mid-September, ‘digital disruptor’ S4 Capital (SFOR) posted a smaller-than-expected increase in underlying first-half revenue and a 30% drop in gross operating profits due to ‘client caution and longer sales cycles, particularly with technology and newer regional and local clients’. Having already warned in July, the firm ‘revised’ its full-year outlook down for a second time, guiding investors to expect negative like-for-like sales growth, a fall in margins and an increase in its debt pile, and sending its shares down 22% on the day. In October, AIM-listed digital media and advertising firm Mission Group (TMG:AIM) reported a whopping 95% drop in first half operating profit, sending its shares down 59% on the day. The firm said margins had been impacted by ‘challenges in the US technology sector and the reduced level of activity in this market’, while cash-flow issues meant net debt more than doubled from a year ago to £14.9 million, ‘driven predominantly by changes in client prepayment behaviour, closely linked to the tightening within the US tech sector’. Chair Julian Hanson-Smith stuck with his forecast of higher full-year revenue but accepted higher operating and interest costs ‘are likely to have an impact on profit growth’. Both S4 Capital and Mission Group’s woes have ultimately been mirrored at FTSE 100 advertising giant WPP (WPP), which posted weaker-than-expected third-quarter revenue due to ‘continued weakness from technology clients and in China’ and also had to cut its full-year underlying sales growth and operating margin forecasts.

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