UK Smaller Companies: Feeling Supersonic

Often overlooked, we believe their long-term outlook is potentially SUPERSONIC.

But first, let’s rewind.

DEFINITELY MAYBE, markets have been volatile. Tariff uncertainty, economic woes and geopolitics have kept investors on their toes.

In the UK, we’ve seen persistent downward pressure on earnings. Foreign exchange upheaval, rising debt levels, and National Insurance increases have all played a part. But the biggest drag has been a slower-than-expected recovery in end markets and subdued demand. In fact, UK corporate earnings revisions have been negative for five consecutive quarters, highlighting the scale of the challenge.

And HALF THE WORLD AWAY, uncertainty around trade continues to cloud the outlook for US economic growth. While headline earnings growth in the US has held up – particularly in technology – the picture beneath is more mixed. Many sectors are showing signs of a slowdown, prompting investors to reallocate some US equity exposure to other geographies, notably the UK.

But STOP CRYING YOUR HEART OUT. While earnings reports have shown wide dispersion, this volatility creates fertile ground for stock pickers. Active managers allocating to companies that are trading well – and where the market is rewarding performance – can unlock powerful long-term returns. Avoiding areas of downgrades can also help drive relative performance.

SOME MIGHT SAY that bid activity in the UK is shrinking the investment universe. In the past 18 months, 18.3% of the FTSE 250’s market cap has been acquired (1). Rather than a negative, however, we see this as a vote of confidence. These bids reflect the value that acquirers – both private and listed – see in UK assets. And the deeper you go into the market cap spectrum, the more compelling the story becomes. Over the past three years, average bid premiums scale with size (1):

Bids don’t need to be a CHAMPAGNE SUPERNOVA. UK small caps are trading at a significant discount to large caps, with forward P/E (price-to-earnings) ratios well below their long-term averages. In fact, valuations are near historic lows relative to large caps, offering what we believe is an entry point for long-term investors.

BETTER MAN: feel the quality

We believe a focus on quality remains essential. In today’s environment, a company’s ability to meet earnings expectations is a key driver of share price performance.

So, what makes a quality business? For us, it starts with the fundamentals: low leverage, diminished earnings volatility, and stable return profiles. But on their own, these metrics only tell part of the story.

We take a broader view; one that considers shifting industry dynamics, customer and supplier relationships, and the strength of a management team’s strategy and execution. This framework helps us to identify companies we believe are best positioned to weather downturns and thrive in expansionary periods.

In short, quality isn’t just about resilience. It’s about sustainable growth through economic cycles.

Diversification benefits: LITTLE BY LITTLE

As we highlighted, a handful of the biggest companies – let’s call them supergroups – have dominated returns in developed markets. In 2024, just eight stocks were responsible for over 50% of global large-cap performance (2).

But small caps are a different story. With thousands of companies across sectors and geographies, it’s impossible for a few names – no matter how well they perform – to drive an entire index.

On top of this, small caps tend to be more domestically focused than larger peers, which can shield them from events overseas. Many often operate in the most dynamic areas of the market, giving them the potential to deliver strong returns over their more sluggish large-cap peers.

Adding smaller companies to a portfolio is typically seen as adding risk. But in the current market environment, we believe the greater risk is missing out on uncorrelated opportunities. Indeed, diversification isn’t just about spreading exposures – it’s about uncovering new sources of return.

It gets better. Historically, UK small caps have demonstrated their ability to deliver robust risk-adjusted returns, particularly in recovery periods following cyclical troughs. Their lower correlation with large caps and global equities enhances their value as a diversification tool within portfolio construction.

Encore: LIVE FOREVER…

“You gotta make it happen.”

Small caps don’t always get the limelight, but many have the potential to become the large-cap idols of tomorrow.

From quality fundamentals to compelling valuations, UK small caps are well-positioned to play a bigger role in portfolios for investors seeking diversification and active opportunities.

And while the UK faces its own fiscal challenges, there are bigger uncertainties elsewhere. One need only look across the pond to see what those entail. The recent flood of overseas capital is testament to the growing global confidence in UK assets.

So, DON’T LOOK BACK IN ANGER. It may be worth considering an allocation to UK small caps now.