With the Premier League kicking off for the new season, fans all around the UK (probably the world) will have reasons for optimism that this is the year everything goes right for their team. Often the evidence is not there to support their optimism – the saying often banded about is that “it’s the hope that kills you” meaning that having no expectations or hopes may be better as your dreams may not be destroyed in a cruel manner.
Anyone associated with UK smaller companies will understand that statement well over the past nine years Brexit first cast a horrible shadow over the UK economy. There always seems be something that stamps out any sort of optimism, such as Covid, political turmoil, rising rates and inflation.
Pessimism around the asset class has been palpable. But we must remember these are growth opportunities, which are under-researched and mispriced. History shows UK small-caps have delivered an average compound annual growth rate (CAGR) of 14% since 1955*, consistently outperforming large-caps in this period. They are also notorious for delivering strong recoveries post various financial crisis like the tech bubble, global financial crises and Covid.
Over the past nine years, UK small-caps have delivered roughly half the returns of the FTSE 100 (56% vs. 111%), and well below global equities (204%)**. They are also trading on a 21.2% discount to long-term P/E averages*.
However, there have been green shoots in the UK economy – with both mid and small-caps crucial in influencing economic growth. Recent economic data has been largely surprising on the upside, energy costs have been falling – as have interest rates – and we also have a strong UK consumer (savings rates at 12% are elevated compared with the long term)***.
Then there is the impact of Donald Trump’s tariffs where, in the UK’s case, it only had a small deficit and was the first to agree a deal. Crucially, US dollar weakness and pound strength is disinflationary – a positive for domestic companies and a headwind for international companies translating into profits and cash. There have also been signs of capital flows moving away from the US towards Europe and the UK.
Since Liberation Day UK small-caps have risen some 22%, but it is from a significant low****. Montanaro UK Income manager Guido Dacie-Lombardo says UK small-caps have not necessarily needed a catalyst for change, more that things have simply reached their nadir. He says there is so much evidence that we are at the bottom in terms of valuations (14.6x) adding that historically over the next five years investors got a return of 13-20% from these points.
Liontrust UK Special Situations co-manager Matthew Tonge says small-caps have outperformed more often than not over longer time horizons but with a trade-off that there can be periods of significant underperformance.
He says: “The magnitude of the recent underperformance relative to large caps, which has been helped by the strong performance of the banks sector, is comparable only to the Russian default/LTCM collapse in the late 90s and the Global Financial Crisis. While this has been a painful period of small-cap underperformance, the historical data shows that previous trough-to-peak recoveries have been significant and rapid.”
Tonge says UK small-caps remain one of the standout areas of value in the market. Based on discounted cash flow valuation he says the entire UK market is trading at a 12% discount (compared with a 40% premium for the US). He adds UK small-caps are currently trading at a 35% discount if valuations were to revert to the DCF-implied intrinsic value^.
He says: “The same is true for profit-based valuation metrics, with the current price/earnings and enterprise value/EBITDA of UK small caps of 16x and 6x respectively compared with much higher multiples for other markets: US (26x and 14x), Europe (16x and 8x), Asia Pacific (16x and 9x).”
Does anything need to change for value to be realised?
There are two key factors that can lift share price returns over the long term: earnings growth and share price re-rating. The first of these has already started to show itself in markets in 2024, and particularly 2025 (the UK small-cap market delivered high single digit returns with no re-rating)^^. Essentially, UK investors are not being asked to pay much for that growth.
The second is a potential re-rating in markets. This comes down to the dreaded word which plagues UK small-caps “sentiment”. The fate of small-caps are often tied to the fate of their economy but, as mentioned, there are signs of improvement.
A research note from Aberdeen points out that recoveries tend to follow a similar pattern^^. It states: “Investors move into large caps and index products first, but once they grow more comfortable with a particular region, they will start to look at small and mid-cap companies, and more active management styles. We have seen this phenomenon in European markets since the start of the year, and believe it could be replicated in the UK.”
Other changes which could prompt a re-rating include investors starting to cast the net beyond the US; surging EU and German defence and infrastructure spending; and growing M&A due to those attractive valuations (acquisition activity for London-listed companies surged in 2024, with total deal value rising to £50bn from £19bn)^^^.
Amati UK Listed Smaller Companies co-manager Scott McKenzie says quoted UK small-caps are not only undervalued versus their peers but also against private companies in the UK, citing the wealth management sector as an example. This internal valuation discrepancy highlights the need to treat this as an opportunity rather than a threat.
McKenzie believes most of the selling of UK small-cap retail funds in this space has now happened and that it will not take much to turn the ship around. He says: “There’s no immediate evidence yet of that happening, but we have to consider the impact of non-UK investors. What we are seeing, both anecdotally and in the markets, is real evidence of US and European investors buying UK assets. That is definitely one of the reasons we think sentiment towards the UK has improved, because overseas asset allocators are now buying it.”
Could the stars be aligning for those willing to be patient with the UK’s burgeoning businesses? It is starting to look more positive but investors must expect bumps in the road from here. However, history shows the last thing you want do is miss the first stage of a recovery, particularly in this area of the market.
*Source: Unicorn, FE Analytics (mid-mid, total return), Deutsche Numbs and Bloomberg, 31 December 2024
**Source: FE Analytics, total returns in pounds sterling, 24 June 2016 and 12 August 2025
***Source: Franklin Templeton, 30 May 2025
****Source: FE Analytics, total returns in pounds sterling, 4 April 2025 and 13 August 2025
^Source: Liontrust, 6 August 2025
^^Source: Aberdeen, 16 May 2025
^^^Source: Unicorn Asset Management, 2025
Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Darius’s views are his own and do not constitute financial advice.
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