UK Small Caps: A reality check

Investors have had plenty of reasons to be pessimistic about the UK economy, but the pervasive gloom may leave them overlooking a potential source of growth and diversification in their portfolios. For UK small and mid cap stocks, sentiment remains significantly out of step with reality and fears over the UK’s domestic growth may be clouding investors' judgment.

The UK’s larger companies have soared since the start of 2025, outpacing even a resurgent S&P 500 . However, the small and mid cap segments have been left in their wake. While the absolute returns have been reasonable, and there have been individual success stories, they remain out of step with the operational performance of companies in this part of the market.

We recognise the challenges for the UK economy. However, the high quality UK small and mid cap companies do not need a strong economy to thrive: the economy is not the stock market. In abrdn UK Smaller Companies Growth Trust, 44% of revenues come from outside the UK, and those drawn from inside the UK come from sectors such as infrastructure, defence or technology, where GDP growth is not the driving force for their profitability.

In spite of the numerous fiscal pressures, and the speculation over tax rises in the budget, these companies have continued to perform well. Overall, UK small companies are forecast to grow their earnings at over 10% for 2025 and many of the companies in our portfolio have delivered even stronger results, including Cranswick, Morgan Sindall and Chemring.

This is not an historical anomaly. Over the long term, smaller companies have delivered earnings growth ahead of the UK market, while the FTSE 250 has delivered an annualised return of 13% over the last 20 years. Earnings growth for all UK markets – FTSE 100, 250 and small cap – is now forecast to be stronger than that of the US. The UK is home to many dynamic, innovative companies that are global leaders in their field. The UK offers compelling opportunities, within infrastructure, within defence, within AI.

The sentiment problem

The problem is sentiment – and more specifically, sentiment among UK investors, who have historically been the natural buyers of UK small and mid cap equities. While UK investors have been on hold, international investors have been steadily increasing their exposure as they recognise the attractiveness of valuations in the UK market and the earnings potential of individual companies.

We see these international buyers joining the share registers. Many appear to be looking to diversify away from US large cap technology where valuations are – on almost any measure – extremely stretched. We also see this international interest manifest in merger and acquisition activity. One-fifth of the FTSE 250 has been acquired since the start of the year. That shows the strategic value that external buyers are seeing in the UK market.

The price an investor pays for the growth they receive is an important determinant of their long-term return. UK small caps are trading on historically low valuations. They are low versus their own history and low versus other markets. These companies are not cheap because of weaker fundamentals, but because they have been neglected.

What could change?

Low valuation is clearly not enough by itself to shift sentiment in the UK market. There have been more than 50 months of outflows seen from UK equities and pessimism is entrenched. Factors that should have improved investor confidence in smaller companies – such as lower interest rates – have failed to make an impact. The same is true for inflation, which now appears to have peaked, but has not yet improved sentiment.

Nevertheless, we are starting to sense a change in mood since the start of the year. Investors are starting to worry about their US large cap exposure. They recognise that their global exposure is, in reality, a significant bet on US technology. They may not want to exit, but they want to control it by allocating elsewhere.

There have been dominant exposures in markets before - Japan, technology, emerging markets - but none of them have continued forever. The AI trend is currently 15 years old. There is more commentary around diversification and bubbles and a real nervousness across the market.

UK small and mid caps offer strong diversification benefits, at bargain basement valuations –FTSE 250 companies trade on half the valuation of those in the S&P 500, yet have the same estimated shareholder returns. Investors are looking for this type of investment profile to reduce volatility and enhance long-term performance. A lot of money has been made in the US, but given the starting valuations, there is an argument that the next decade may look different.

The case for small caps

With valuations deeply discounted and investors across the globe looking to rotate away from US mega-caps, investors have a rare opportunity to buy into an asset class with proven growth characteristics while sentiment is still weak.

On the abrdn UK Smaller Companies Growth Trust, we have companies such as Rotork, which makes flow control and actuators, or vending machine business ME Group that is growing aggressively through acquisition. We hold Morgan Sindall, which is taking full advantage of a strong backdrop for UK infrastructure, while Chemring and Avon Technologies are benefitting from increased defence spending.

UK Smaller companies present a rare opportunity: they offer a combination of good earnings growth, low valuations and diversification potential, at a time when investors are receptive to new ideas. Investors should not let short-term pessimism over the UK economy obscure the real value inherent in the UK’s unsung heroes.

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