UK small caps: Good things come in small packages

UK small cap shares have consistently outperformed those of larger companies. According to research by Elroy Dimson, Paul Marsh and Mike Staunton for UBS, between 1900 and the end of 2025, the smallest shares in the FTSE have beaten the wider market by an average of around 2.5% a year.

Since 2010, however, that trend has reversed. It has since been what Cassie Herlihy, portfolio manager of Henderson Smaller Companies Investment Trust, calls “something of a lost decade for UK small caps”.

Indeed, depending on which index you use as a measure, small caps have lagged the wider market by about 5%-6% for the past ten years. Yet signs of improvement in the wider economy, government efforts to encourage institutions (especially pension funds) to invest more in UK shares and a wave of takeovers indicate we are at an “inflection point”, says Henry Ince, equity strategy analyst at Morningstar.

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UK small caps “has been driven much more by an onslaught of external factors than by any change in the quality of the underlying businesses”, says Herlihy. When the UK voted to leave the EU in 2016, the country “essentially fell out of favour with international investors, who increasingly looked elsewhere”, she adds. Businesses focused on the domestic market were also some of the “hardest hit” by Covid, as many smaller retailers, restaurants and leisure companies lost their revenues overnight.

The pain didn’t end with the pandemic. The post-Covid readjustment, the Russian invasion of Ukraine and the Liz Truss mini-Budget drove increases in inflation and interest rates. This has made it more expensive to invest for growth, which has had a bigger impact on smaller businesses, who tend to be more focused on expansion. Political instability has also “created uncertainty and a lack of confidence, which has made it harder for businesses to make decisions”.

Pensions funds joined the flight from UK equities. Twenty-five years ago, at the turn of the millennium, British pension funds had about half their assets invested in UK equities, says Georgina Brittain, manager of the JPMorgan UK Small Cap Growth & Income Trust. This has now fallen to less than 5% as the money flows into global benchmarks instead. This “massive outflow of money” has depressed prices. Recent tax changes haven’t helped, says Vishal Bhatia, senior fund manager of the J O Hambro Capital Management (JOHCM) UK Dynamic Fund. Most shares listed on the Aim junior market were once exempt from inheritance tax. No longer.

The poor performance in recent years may have been frustrating for investors, but it means that valuations now are “exceptionally low, both in absolute terms and relative to other markets”, says Roland Arnold, portfolio manager of the BlackRock Smaller Companies Trust. We are seeing valuations “typically associated with periods of extreme economic stress”, even though the underlying situation “does not justify such depressed levels”. The UK market is “already cheap in a global context, but smaller companies are trading at a further discount within that”.

The broader UK economy could help change the market’s mind, says Herlihy. “Cautious optimism” at the start of the year was marred by the conflict in the Middle East, but even this shock has probably only “delayed” the arrival of interest-rate cuts. Inflation “is much less entrenched than it was in the immediate aftermath of Covid”, which gives policymakers more freedom to focus on stimulating growth. Economic growth should also be helped along by the fact that company and household balance sheets remain strong.

Ince is even more bullish about the prospects for the UK economy. Several companies, traditionally seen as bellwethers for consumer spending, such as Halfords, Young’s and Greggs, have recently reported strong figures and have upgraded their expectations for the near future. Consumer confidence is at a two-year high and GDP growth, while not particularly strong, is “not awful” either. “We are already seeing some green shoots of recovery in the small cap market, which has outperformed larger caps over the last six months.”

Meanwhile, institutional investment flows back into UK shares could also help to boost small caps, says Helen Curtis, a partner at Devonshires. They may not have much choice. Under the Mansion House Accord, major pension providers have “committed to investing 10% of workplace pension portfolios in productive assets by 2030, with at least 5% earmarked for UK investments”. And the government may dial up the pressure further on pension funds to induce larger investment into the UK. This may take the form of a “carrot” of incentives, such as lower regulatory requirements and reforms to listing requirements; or a “stick”, whereby they may either be pressured to invest more in UK shares by raising the existing voluntary target, or it may be made a mandatory minimum requirement.

Some sort of formal mandate looks “unlikely” in the near term, says Herlihy. But there is “enough noise around this that some more of the forward-thinking pension funds may move ahead of the herd”, which could lead others to follow. Already there are signs that pension-fund managers are “starting to question the assumption that the US market will always do better than the UK”. Many are beginning to look towards the UK as a “relatively safe, attractively valued way for investors to diversify” away from the AI boom.

And there doesn’t need to be a sudden flood of institutional money to boost small caps – “just stemming the persistent outflows would be enough to start underpinning valuations, particularly given how little it takes to move the needle in the less liquid small cap market”, says Herlihy. Indeed, pension-fund holdings of UK shares are so low “that any increase would provide a significant boost”, says Brittain.

The most immediate catalyst that could accelerate small cap fortunes is to be found in mergers and acquisitions (M&A). Cheap valuations have led to a big spike in the number of smaller companies being taken over. This M&A boom has mostly been the work of private-equity firms, who were getting “some of the bargains of their lives”, says Brittain. More recently they have been joined by large firms buying up “some really cheap rivals”. It is now more of a 60:40 split between private equity and large firms. Some of the premiums the acquiring companies are prepared to pay have been “eye watering”, says Ince. Over the past three years, nine of the small cap holdings in the JOHCM UK Dynamic Fund have been acquired at an average premium of around 67%, with the highest reaching 169%, says Bhatia.

Naturally, not everyone is happy about this, says Ince. Many UK-focused fund managers and investment trusts are “almost having to apologise to their investors for the fact that they are having to sell these companies that they wanted to hold on to for the long-term”. But at the end of the day, the fact that an informed buyer is willing to pay a 40%, 50%, or even 80% premium “tells you how much of a mispricing there might be”.

This year alone, deals involving FTSE Small Cap constituents have amounted to about £3.9 billion, equivalent to about 10% of the index’s value, with a further £2 billion of activity across Aim, says Henry Norton of Arbuthnot Latham. Across the wider UK market, takeover premiums have averaged around 45%, showing the significant premium that strategic and private-market buyers have been willing to pay over prevailing valuations on public markets. Share buybacks are another route for companies to take advantage of depressed valuations “and we are seeing increasing use of them to support returns”.

A combination of undervaluation and an improving environment makes UK small cap shares look very attractive, says Ince, but investors still need to be discriminating. After all, sometimes things are cheap for a reason and investors have to avoid such “value traps”. It pays to do your research and a “bit of legwork can pay dividends” as the UK smaller-companies market “remains an under-researched area”, says Arnold.

The food-production sector is particularly worth exploring “because demand tends to remain relatively stable regardless of the economic backdrop”, says Arnold. Similarly, many infrastructure businesses tend to have long-term order books that “provide greater certainty over future revenues”. There are also opportunities among capital-goods companies, which are set to benefit “from an increase in capital expenditure, following several years in which management teams have held back on investment”.

Investors should pay particular attention to small caps that focus on “specialist healthcare and diagnostics and medical technology companies, alongside those businesses supplying the tools, software, infrastructure and specialist services that enable digital transformation”, says Curtis. It’s also worth looking at the names that have sold off due to fears of disruption from AI . The threat from AI, although real, has been exaggerated, but many small companies tend to be more agile at dealing with threats and quicker to take advantage of change than their larger counterparts.

Rather than try to identify promising sectors, it might be a better idea to focus on individual small caps that have “fundamentally strong businesses whose valuations have fallen primarily because capital has left the asset class rather than because the underlying businesses have deteriorated”, says Norton. Companies with “strong cash generation, high margins, low financial leverage and management teams capable of driving their own improvement should be better placed to prosper without relying entirely on a strong UK economy”. These characteristics “can also make companies attractive potential takeover or merger candidates”.

Small cap investors should take the bottom-up approach of focusing on the company rather than the industry in which it operates, agrees Nikki Martin, senior portfolio manager of global equities at Sarasin & Partners. One indication of hidden value is a company’s ability to dominate a specialist market overseas, which indicates good management and these firms tend to be undervalued as they are “priced on UK multiples, even though they are earning international revenues”.

(LSE: CUKS). This tracks the MSCI United Kingdom Small-Cap Net index. Some of the largest holdings, such as Weir, St. James’s Place and Games Workshop, have market capitalisations of around £5 billion, which would make them mid caps according to some definitions, but there are 193 holdings overall, and the median has a market capitalisation of around £1.3 billion. The average price-to-earnings ratio is 14.5 times and the fund has a total expense ratio of 0.53%.

A more actively managed small-cap option is the JPMorgan UK Small Cap Growth & Income trust (LSE: JUGI). It’s run by Georgina Brittain and Katen Patel and targets fast-growing firms with market capitalisations of between £100 million and £4 billion and aims to strike a balance between “value and momentum”. It trades at a discount to book value (net assets) of 8.7%. Over the last decade, its shares have returned a total of 199.4%, compared with just 66.4% for its benchmark (the FTSE Small Cap, excluding investment trusts). It has an ongoing charge of 0.75%. It is widely expected to merge with Aberdeen UK Smaller Companies Growth Trust in the near future.

The largest holding in the trust’s portfolio is Keller Group (LSE: KLR), with a market capitalisation of £2.16 billion. It focuses on construction, especially preparing foundations for buildings. Its involvement in the data-centre boom gives it amazing growth potential, says Brittain. It is “really coming into its own right now”. Sales have grown by nearly half between 2020 and 2025, but it is expected to keep on growing, and the shares still only trade at 11.8 times 2027 earnings, with a dividend yield of 2.7%.

Another small-cap construction-related company worth looking at is Sigmaroc (LSE: SRC), which mines, refines and delivers minerals, such as granite and limestone, which are used in building. It has an “excellent, entrepreneurial management team”, says Mirabaud Asset Management’s Hywel Franklin, who have created a company that is “extremely cash generative and attractively valued”. It has scope to “benefit further from infrastructure spending programmes on the continent as they materialise”. Sigmaroc’s market capitalisation is £1.39 billion and the shares trade at just ten times 2027 earnings.

A smaller company that looks interesting is The Beauty Tech Group (LSE: TBTG), with a market capitalisation of £547 million. It specialises in new beauty technologies that you use at home and has “delivered multiple upgrades” since its flotation on the stock market just over a year ago, says Bhatia. Its CurrentBody Skin brand is “firmly established in the premium segment” of the market. Strong cash generation and a net cash balance sheet support an ongoing share-buyback programme, and the company has a rich launch pipeline, including the new Series 3 LED mask, which should “accelerate operational momentum”.

Boku (LSE: BOKU), with a market capitalisation of £366 billion, helps technology firms accept local payment methods, especially in emerging markets where fewer people have access to traditional financial infrastructure. Clients include Meta, Amazon, Netflix and Google. The recently announced partnership with Stripe is particularly impressive, says Janus Henderson’s Cassie Herlihy, and is “a major validation of Boku’s technology and infrastructure”, as well as having “the potential to open Boku up to a much broader merchant base”. Despite more than doubling sales between 2020 and 2025, Boku’s shares still trade at less than 18 times expected 2027 earnings.