Small-cap stocks have been abandoned by investors. That is bad news not only for the companies themselves, but for the wider UK economy. In the past, the smallest businesses listed on the London stock market have played an important role in Britain's economy. Ambitious young companies could raise money, expand their operations and, if successful, grow into much larger businesses. Investors who backed them early often enjoyed excellent returns along the way.

Today, that system is breaking down. A series of regulatory changes and industry shifts has steadily diverted money away from smaller companies and towards the largest firms in the market. The result is a funding drought for many promising businesses and fewer opportunities for savers seeking long-term growth. Because these changes are now deeply embedded, a reversal looks unlikely anytime soon.

That does not mean investors should ignore small caps. In fact, the current environment may offer some of the best opportunities seen for years. But investors need to adapt. Simply buying cheap shares and waiting for the market to recognise their value is no longer enough. Many small-cap stocks remain overlooked for years. The most attractive opportunities are often companies that can grow rapidly, recover from temporary setbacks, or unlock value through corporate activity. In other words, investors should be looking for tomorrow's mid-caps rather than today's statistically cheap shares.

Finding bargains in small-cap stocks isn't enough

The UK stock market is shrinking as listed companies disappear through takeovers, private-equity bids and delistings. At the same time, fewer investors are directing money towards small caps. As a result, prices at the lower end of the market often fail to reflect the underlying performance of a business. In theory, that should make stockpicking easier. If markets become less efficient, bargains should become more common. The problem is that cheap shares can now remain cheap for a long time. Buying undervalued stocks only works if someone eventually notices that they are undervalued.

To understand why this is happening, it helps to look at how the wealth-management industry has changed. Not long ago, stockbrokers and fund managers devoted considerable resources to researching smaller companies and allocating clients' capital across the market. That process helped ensure that money flowed to promising businesses and that share prices broadly reflected reality. Things have changed. Building bespoke portfolios has become increasingly expensive and administratively burdensome. Faced with rising compliance requirements and growing scrutiny over fees, many advisers have stopped making investment decisions themselves. Clumsy rules from the regulator triggered this shift. To eliminate compliance risks and operational costs, advisers stopped managing money altogether. Instead, they outsourced the process entirely to mass-market model-portfolio services (MPS).

That trend has concentrated massive wealth into a handful of firms. Four dominant discretionary managers now control the bulk of the UK MPS market. Quilter WealthSelect, Tatton Investment Management, Timeline Portfolios and AJ Bell Investments manage more than £70 billion combined and are growing rapidly. Today, the MPS marketplace relies almost entirely on passive tracking funds. Driven by regulatory pressure to keep fees low, providers invest in cheap index funds that replicate the wider market. Human judgment has been replaced by algorithms. Instead of analysing whether a business is worth buying, a passive fund allocates cash based purely on how large a company it already is.

The big four allocate a combined £9 billion to the UK stock market. Yet tracing the money down to the underlying holdings reveals that almost none of it reaches smaller companies. When investment committees use passive UK equity trackers, index rules determine where the money goes. These index rules explain why the largest wealth managers hold next to nothing in smaller companies. In the past, a balanced portfolio routinely allocated several percent to small caps. Today, that support has vanished. Quilter WealthSelect and Tatton Investment

Management control around £50 billion between them, yet their reliance on broad market benchmarks dilutes actual small-cap exposure to around 0.3% of total assets. AJ Bell relies on trackers that systematically lop off the bottom 3% of the investable market, so its allocation to pure small caps sits at virtually nothing.

This starvation of capital has triggered a destructive feedback loop, worsened by past regulatory mistakes. New rules permanently damaged the stock market by forcing brokers to charge separately for research and trading. When active funds dominated the market, brokers employed armies of researchers to write detailed reports, helping fund managers choose where to invest. In the past, brokers spent time analysing small companies to drum up interest among investors and find buyers for their shares, funding the work through trading in large companies. This research gave smaller firms visibility and kept their share prices accurate. Once the regulator banned this so-called bundling, the commercial model for small-cap broking collapsed because passive tracking funds do not buy research.

Analysts' coverage for companies valued under £250 million has all but vanished. Today, hundreds of listed British businesses are completely ignored by the market. With no regular broker reports, private investors have to work much harder, using specialised resources to find out how well these businesses are performing. Institutional investors will not buy shares in a company that nobody covers and brokers will not spend money writing about companies that the big wealth platforms are blocked from buying. Investing is becoming a purely automated exercise driven by index size, leaving high-quality small companies completely cut off.

How to find the right small-cap stocks

Yet all is not lost. For savvy investors who understand this breakdown, the dysfunction creates a lucrative hunting ground. To succeed, investors must leave behind old-style value investing. Buying a stock simply because it looks cheap on paper is a mistake, as passive investing means that value stocks may remain cheap forever. Instead, investors must look through these three specific lenses to find the stocks that can entice money from investors.

The first lens focuses attention on structural growth – that is, high-quality businesses expanding their operations and becoming more valuable in the process, generating high levels of real growth by deploying a proven commercial formula. This could make them the mid-caps of the future. When a company grows its earnings consistently, the compounding effect eventually overwhelms the lack of market interest. Even if the valuation multiple stays depressed, the sheer scale of the underlying profit expansion forces the share price higher, dragging the business out of the small-cap index to where there are far more investors.

The second lens reveals recovery plays that have hit cyclical lows. The turbulent economy of the last few years has battered corporate earnings, causing share prices to collapse and pushing formerly substantial businesses down into the small-cap sector. But this is often a temporary condition driven by external cyclical factors rather than permanent structural decline. The goal is to identify businesses that have survived the worst of the downturn and have the strength to capitalise on the inevitable rebound. When the cycle turns, these companies will enjoy a dramatic recovery, delivering an explosive bounce in earnings.

The third lens focuses on corporate activity – revealing under-the-radar businesses where an activist investor has built a stake to force operational change, unlock shareholder value or streamline the group. The activity can take many forms – from cost-cutting programmes to selling off non-core assets, or shrinking the share count using excess cash – and create prime targets for full takeovers by external corporate buyers. Private-equity firms and larger international corporations routinely scan the UK small-cap market for high-quality assets trading at steep discounts to their private market value. When a corporate buyer launches a full cash takeover bid, the market reaction can deliver value for shareholders. The following companies are examples that meet some of these three criteria.

Nine of the best UK small-cap stocks

Fintel (LSE: FNTL) is a structurally growing business that is priced as if it is not. It provides critical compliance data and fintech software to thousands of British financial advisers through its dominant SimplyBiz and Defaqto brands. The result is a highly predictable stream of recurring subscription income, with demand likely to increase as regulation across the retail wealth sector becomes more stringent. Yet the market prices the combined entity at a steep discount to the price that other similar businesses have been acquired for. This allows investors to buy a highly scalable fintech at a bargain valuation, long before the compounding earnings force a market rerating.

Software Circle (LSE: SFT) aims to generate structural growth via a disciplined consolidation strategy. It is actively buying up niche software businesses within highly fragmented sectors across the UK. Operations are at an early stage, but management is progressing sensibly, securing acquisitions at very attractive multiples while maintaining a lean head office and a decentralised operational structure. This playbook closely mirrors the model of other firms that have generated immense long-term wealth. Though tiny today, this firm has all the traits necessary to deliver exceptional multi-year shareholder returns.

Amcomri Group (LSE: AMCO) operates a strict buy, improve, build strategy across the fragmented UK engineering and manufacturing sectors. The business targets high-quality industrial firms facing the owner's retirement, acquiring them at low single-digit multiples before driving organic margin improvements. This roll-up model generates highly predictable structural growth completely independent of the wider macroeconomic backdrop. Recent final results confirm this operational formula is working, with pre-tax profits significantly ahead of market expectations.

Vanquis Banking Group (LSE: VANQ) is a cyclical recovery play. Formerly a FTSE 100 stock called Provident Financial, the lender shrank into a micro-cap minnow after major operational disasters. Management has finished cleaning up the wreckage, yet the market still prices the shares as if collapse is certain. Vanquis provides credit cards and vehicle finance to millions of sub-prime borrowers that mainstream banks ignore. Management targets mid-teens returns on tangible equity by 2027. If they deliver, the shares will be unbelievably cheap and a sharp market rerating should drive the share price up to reward investors who timed the recovery correctly. The bank operates as a far better business than its depressed price reflects.

Focusrite (LSE: TUNE) is a clear case of a former stockmarket darling caught at a cyclical low. The audio-products group enjoyed an unprecedented sales boom during the pandemic. However, as global demand normalised, the business wrestled with severe inventory overstocking and costly distribution headaches that clouded performance for several years. Recent trading updates indicate that these operational problems are finally clearing. Trading on a low multiple of its current depressed earnings, Focusrite offers massive upside. As underlying profits recover toward historic levels, this corporate recovery could trigger a rise to a much higher share price.

Marshalls (LSE: MSLH) serves as another example of a business hitting a cyclical low, operating as a highly respected supplier to the struggling UK building industry. High interest rates, inflation and uncertainty about policy have brought domestic construction to its knees, dragging the business down with it. This company once commanded a premium valuation as a well-known mid-cap, but it has now fallen into obscurity. The shares historically traded at a multiple to book value, yet they currently languish at a clear discount. When building activity inevitably recovers, Marshalls will benefit immensely, potentially driving a sharp recovery in its share price.

Capita (LSE: CPI) is another cyclical recovery play, a fallen angel offering massive potential for recovery. The outsourcing giant once sat in the FTSE 100 before a collapse dragged it down to micro-cap levels. New management has aggressively cleaned up the balance sheet, selling non-core software assets to eliminate debt. The business still generates more than £2.4 billion in annual revenues, yet trades at a deeply depressed valuation. This turnaround relies entirely on internal cost-cutting rather than macroeconomic growth. As administrative cost-cutting leaves more free cash in the bank, the shares could enjoy a substantial and justified market rerating.

Funding Circle (LSE: FCH) is an underappreciated growth story driven by massive operational gearing. The digital platform matches small business borrowers with institutional lenders. This matching model requires very few incremental cost rises to service new volume. This structural efficiency allows expanding revenues to drop straight to the bottom line. Pre-tax profits recently surged from £3.4 billion to £20.3 billion and are on track almost to double again to £35 million this year. The wider market remains blind to this compounding scaleability, mispricing a high-margin financial matchmaker as just another lender.

SDI Group (LSE: SDI) offers a double whammy by combining structural growth with a cyclical margin recovery. The company runs a highly disciplined buy-and-build strategy, acquiring niche scientific-instrument businesses that specialise in optics and photonics for laboratories. This consolidation model delivered excellent long-term returns until a recent downturn in its core scientific end markets depressed the group's earnings. This temporary pain leaves the shares trading at a very cheap valuation. As laboratory budgets normalise and operating margins recover, investors could capture the combination of compounding growth and an explosive rebound.

The best specialist funds in the sector

Picking individual micro-cap stocks requires patience and knowledge, and is certainly not for everyone. For investors who prefer to delegate the task, backing a specialist fund manager with a proven record is sensible. Two specific investment trusts have proved their ability to navigate these markets with skill. The lead manager of Rockwood Strategic (LSE: RKW), Richard Staveley, has more than 25 years of experience and runs a concentrated portfolio of undervalued businesses. He engages directly with boards to unlock value, a strategy that has delivered a stellar record. Staveley targets unloved, mispriced assets and drags them through a turnaround process until the wider market is forced to pay attention.

For those looking even further down the market scale, Onward Opportunities (LSE: ONWD) provides exposure to some of the smallest companies listed in the UK. Lead manager Laurence Hulse launched the trust in March 2023 on the Aim junior market and took it to the main market in April 2026. He deliberately operates in the smallest, most illiquid territory and his execution has been outstanding, delivering a very good performance since the trust's inception.

For those selecting individual stocks today, three of the stocks mentioned above look particularly interesting. Focusrite is a cyclical recovery play that has finally cleared some post-pandemic hurdles and positioned its manufacturing operations for a strong earnings recovery. Vanquis Banking Group remains absurdly mispriced, trading at a steep discount to its underlying net asset value while the market completely ignores its mid-teens profitability targets. And Software Circle provides an underappreciated growth story with a disciplined, decentralised model for integrating niche acquisitions efficiently. Investors who back these stocks will gain direct exposure to tangibly improving businesses.

For investors who prefer to delegate the stockpicking, Rockwood Strategic is the ideal vehicle. It has a long record of active engagement by the board and offers instant diversification across a concentrated basket of deeply undervalued turnaround plays.

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With a focus on British small-cap stocks, the Henderson Smaller Companies investment trust seeks to deliver long-term capital and income growth by investing in UK-listed companies at their most exciting stage of development. Our stock-picking approach is designed to identify this growth before others do, capturing the small-cap premium through disciplined valuation, ensuring we invest only where prices do not yet fully reflect a company's strong fundamentals in terms of growth and cash generation.

A tumultuous decade for British small-cap stocks, beginning with nerves around the EU referendum and culminating in an energy crisis and a sharp rise in interest rates, has left this part of the market unloved, overlooked and, most importantly, awash with value. We highlight three British small-cap stocks that are cheap compared with international peers, with precedent transactions (the price that peers have recently been purchased for in merger and acquisition deals) and with their own history.

Promising British small-cap stocks for your portfolio

Oxford Biomedica (LSE: OXB) is a contract development and manufacturing organisation (CDMO) specialising in manufacturing viral vectors for cell and gene therapy, treatments used to combat cancer and rare genetic diseases and used in a growing range of new applications. It is one of only a handful of players globally capable of developing these technologies at a commercial scale. The market is growing at more than 20% a year, and the firm has set ambitious targets to more than double revenues by 2028, underpinned by increased capacity coming online at its Oxford (UK) and Durham (US) facilities. The shares trade at about a 30% discount to internationally listed peers despite faster forecast sales and earnings growth. Meaningful consolidation across the CDMO sector in recent years and interest from private-equity firm EQT make the stock look even more attractive.

In a world where financial-services firms are fighting to get closer to their clients, Rathbones (LSE: RAT), which provides financial planning and investment advice, is well-positioned. Ageing populations and rising personal and wealth taxes are driving demand. The shares trade on a steep discount to multiples recently paid by NatWest for smaller competitor Evelyn Partners and offer an attractive dividend yield.

Everplay (LSE: EVPL) is an independent video-game developer and publisher with a resilient business model, operating in a structurally growing part of an already large market. In the premium “AA” and “AAA” segment of the market, firms sink large sums into individual titles and need big hits to drive returns. The smaller, independent players are different. Everplay spends on average £1 million-£1.5 million per game, releasing about ten new titles a year, meaning risk is diversified and earnings are not dependent on any single release. About 75% of earnings are underpinned by a strong back catalogue of well-known titles that continue to generate revenue – Worms, for example, is more than 20 years old and still makes money.

It also owns simulation-gaming business Astragon, with its niche customer base, and StoryToys, a mobile “edutainment” division targeting younger players and recurring revenues. Everplay is a leading scaled player in its sector and, despite resilient growth and strong cash generation, a robust pipeline for this year and significant firepower to pursue mergers and acquisitions to drive incremental growth, the shares trade at just over seven times EV/Ebitda – a significant discount to peers, precedent transactions and its own history.

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UK investors looking for income often concentrate on FTSE 100 companies. But it's not just the more defensive, established giants that can deliver attractive dividend yields; mid-sized and smaller companies can too. These smaller businesses tend to be more cyclical and faster growing, helping to drive earnings and dividend growth, which can boost total returns over time. “Time” is the word to emphasise there. Sometimes you have to wait for them to fulfil their exciting capital-growth potential. But if you've targeted good, well-managed companies paying out dividends, you know you're being paid to wait. This area of the market can go through difficult patches, but that can open up opportunities to buy at attractive prices and enhance the dividend rewards further.

It's in one of those difficult patches now. Smaller companies have substantially underperformed their large-cap peers. In my view, this is because smaller companies are more domestic in their exposure at a time when the UK economy is roughly flatlining. And they're more cyclical at a time when there are question marks about the global and UK economies. But this prolonged underperformance has arguably thrown up some interesting value opportunities. Here are three holdings within our multi-cap, income-focused Lowland Investment Company that we think illustrate the potential benefits for long-term investors willing to hunt among smaller companies, as well as larger ones, for dividend yield and potential capital growth.

Three UK smaller companies to consider

Marshalls (LSE: MSLH) makes building products such as paving stones and roofing materials. It's trading on less than ten times forecast earnings, on an earnings number that is depressed compared with its history. End markets, particularly in landscaping products, are challenged, but while you wait for things to pick up there is a dividend yield that is more than 5% and roughly twice covered by earnings. There are also divisions within the group that are more resilient. Its solar panels division, for example, has grown sales strongly in recent years.

Shaftesbury Capital (LSE: SHC) owns much of London's West End, including Covent Garden, Carnaby Street and Chinatown – a mix of retail, office and residential properties. It's trading on a roughly 40% discount to net asset value. The market is gloomy about property, but vacancy rates in this portfolio are very low. The dividend yield is more than 3% and the managers are targeting rental growth of 5%-7% a year. This should mean the company has the potential to grow that dividend sustainably to offset inflation.

Hilton Food Group (LSE: HFG) is a meat packer with customers globally, such as Tesco in the UK and Woolworths in Australia. It has struggled in recent years after expanding into adjacent areas, such as white fish and vegetarian food. But the current CEO seems to be shifting focus back to its core skills. The shares trade on a price-earnings ratio in the low teens and a dividend yield covered by earnings of more than 6%. Hilton is now investing in new growth opportunities. It's starting to work with Walmart in Canada, a venture that might eventually spin out to other countries covered by the supermarket chain. If people can feel confident the problems have been dealt with, they may get more excited about growth opportunities again.

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UK small caps have been left under-owned by investors' preferences for large-cap stocks in recent times, creating a significant valuation gap. However, as macroeconomic pressures stabilise and confidence returns, this gap is beginning to narrow. The strength of many UK small caps is becoming apparent. They are often more agile than their larger peers, operate in attractive niche markets and remain significantly under-researched – creating a fertile hunting ground for mispriced opportunities. We hold a concentrated portfolio of high-quality UK small caps, and take meaningful stakes and engage directly with management teams. This allows us to support long-term value creation and tune out short-term market noise. Across the portfolio, we are seeing a growing number of smaller companies reaching clear inflection points, yet share prices remain anchored to outdated narratives.

Three UK small caps to consider for your portfolio

The UK wealth-management sector continues to benefit from strong long-term structural tailwinds such as rising levels of household wealth and supportive government policies. Brooks Macdonald (LSE: BRK) looks like an interesting recovery story in that sector. The firm's recent transformation and investment initiatives are beginning to show results. This is complemented by rising momentum across its model portfolio service, which now represents 40% of assets and is growing at double digits. The company has recently returned to overall net asset growth, having now delivered two successive quarters of positive net flows. If sustained, this will show that management's efforts are paying off and could act as a catalyst for a substantial rerating. The firm could also become a takeover target. It is a valuable asset as a standalone platform, or in combination with another player.

Netcall (Aim: NET) also looks compelling. It is a leader in software related to customer engagement and business process automation, and the group serves industries including healthcare, local government and financial services. Its move to offering products from the cloud has transformed the business and accelerated top-line growth to double digits. It remains profitable and has a strong balance sheet. The investment case is being strengthened by AI. Netcall helps public-sector clients implement AI as part of broader efforts to automate services. Many of the relevant bodies lack in-house IT capabilities and therefore require a trusted partner to help them extract efficiency gains from new technology. This is where Netcall comes in, and its business strategy aligns directly with central government's push to digitise public services. The shares have fallen recently, caught up in the “SaaSpocalypse” narrative that AI will make many software providers obsolete. We think this misreads the situation. Netcall isn't being disrupted by AI – it is helping to deliver it.

Everplay (LSE: EVPL) is a developer and publisher of video games. Its model of acquiring and developing games made by independent producers limits the risks around development and improves the quality of earnings – 75%-90% of annual revenue is typically generated from a back catalogue of hundreds of titles, providing diversification and resilience. Recent weakness in the share price reflects concerns about AI's impact on the development of gaming. But Everplay's strength lies in identifying and acquiring successful intellectual property and managing it over time. If AI enables developers to create more content quickly and cheaply, this will increase the volume and make curation and selection even more valuable. Recent management changes support the investment case. We believe Everplay is a well-positioned, scaled player in a fragmented industry, with potential to consolidate further or eventually become an acquisition target.

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Investing in UK small-cap stocks does not necessarily mean exposure to businesses struggling against larger rivals. On the contrary, we actively seek smaller companies that dominate niches. They may not be FTSE 100 giants, but they are leaders in their specialist areas, with the scale, data and strategic positioning to thrive. The UK small-cap sector is rich with such firms. Market leadership in a niche area confers several key advantages. It can enhance pricing power, which is especially valuable in today's inflationary environment, increasing the likelihood of profits. We place equal importance on competitive barriers and the structure of the industry in which the company operates. Without barriers to entry, competitors can swiftly erode profit margins even as demand grows. Here are three examples of smaller companies that we believe have an edge.

UK small-cap stocks to consider for your portfolio

MONY Group (LSE: MONY), owner of the MoneySuperMarket and Money Saving Expert brands, is one of the UK's market-leading price-comparison platforms. It may not be the largest in every category, but it has the broadest offering, which is important because by offering a multitude of products – for example, current accounts, broadband, energy, loans and travel insurance – MONY frequently interacts with its customers. Its rewards programme, SuperSaveClub, goes further in helping to convert a one-off transaction into a recurring revenue stream and reduces MONY's reliance on Google and television advertising. It is growing quickly: it had 2.1 million members and accounted for 16% of group revenues in 2025.

Concerns about the risks posed by AI have brought the shares down to attractive levels. There are also a number of barriers to entry that will help cement MONY's competitive advantages, including regulation, links to the multitude of insurers and brand strength. It says something that Amazon attempted to enter this market in 2022, but pulled out 15 months later.

Moonpig (LSE: MOON) is a UK small-cap stock that dominates the country's online greetings-cards market with a 70% share. That means data. Moonpig has more than 100 million customer reminders on its system, which it is using to convert one-off purchases into repeat business. Its subscription model, Moonpig Plus, has surpassed one million customers, and they are using the service not only to buy cards more often, but also to spend more by adding gifts. The business floated at an inflated price. Five years later, and with the share price about 50% lower, it now looks like a good investment.

Victorian Plumbing (LSE: VIC) is another market leader. Its acquisition of its (near) namesake Victoria Plum has cemented its strong market position, and the firm can now invest far more effectively in its brand. Its recent move to a new warehouse should enable it to scale, and it could double its sales within its existing infrastructure. Like Moonpig, Victorian Plumbing was a beneficiary of Covid and was overvalued at its initial public offering. More recently, the shares have been hit by concerns about UK consumer spending and its decision to invest in entering the homewares market. These concerns are temporary. The Iran conflict is pushing up inflation, delaying interest-rate cuts and has further eroded fragile consumer confidence. Nevertheless, consumer savings rates are high, and household debt-to-income levels are at a generational low. We see this as a strong platform for when consumers' confidence does recover.

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For the last decade, it has been easy – and highly profitable – to allocate the marginal pound in your portfolio to the largest American technology companies. However, it now looks as if the “easy money” has already been made in this trade and investors should consider where growth will come from over the next decade, not the last one.

For investors considering opportunities away from the US, Europe is beginning to step back into the spotlight. Contrary to popular belief, European stocks are not a legacy trade. Although the continent's large-cap indices lean heavily on traditional sectors, its small- and mid-cap segments – which comprise more than 2,000 companies – are awash with innovative businesses, which often command a dominant share of their sectors while being virtually unknown to most investors.

Three European stocks to consider

Our fund heads off the beaten track to identify European stocks that may be beyond the radar screens of larger funds and outside the reach of most analysts. Alongside a proprietary screening process, we travel around Europe on a weekly basis meeting management teams to assist us in building a high-conviction, concentrated portfolio of European stocks. Because we invest in smaller companies, we can build very deep relationships with them, engaging closely with management.

This part of the market has been through a challenging period in recent years, but the pandemic, the resurgence of inflation and the subsequent rise in interest rates have forced businesses to adapt, making European small-caps far more resilient than most people realise. With the market only just beginning to recognise the quality of these businesses, they may not remain small caps for long.

As the continent faces up to its need significantly to renew and strengthen its often creaking infrastructure, Netherlands-based Royal BAM Group (Amsterdam: BAMNB), a construction and infrastructure company, is well placed to profit. The group could be a major beneficiary of greater government spending on infrastructure in the coming years and it has a significant backlog of orders coming through its pipeline. The market has begun to recognise the quality of the company in recent years, but we believe it has further to run as infrastructure spending continues to gather pace across Europe.

AcadeMedia (Stockholm: ACAD) is a Swedish company that has broadened its geographic footprint across the Nordics and into Germany, providing early-years education. It is largely disconnected from macroeconomic shocks such as the oil price or US tariffs and enjoys a dominant position in its sector. The business is highly cash-generative and demand for its service in the future should remain robust. The stock is trading on an attractive price/earnings ratio of 11, making it an interesting long-term opportunity.

Einhell (Frankfurt: EIN), based in the Bavarian countryside, is a developer and manufacturer of DIY and power tools. The business led the way in developing battery-operated tools and is globally competitive on a cost basis, even against Chinese competitors. Einhell is starting to expand its reach across Europe and further afield.

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UK small-cap stocks haven't had an easy ride in recent years. With shifting interest rates and the outlook for the economy looking uncertain, many investors have gravitated towards the perceived safety of larger, more global companies instead. Look a little closer and a different picture emerges.

Across the UK small-cap market there are businesses continuing to grow steadily, strengthen their financial positions and build momentum. In many cases, this progress is being driven by long-term trends that are less dependent on the ups and downs of the wider economy. From infrastructure to healthcare and specialist services, these companies are benefiting from structural sources of demand that can support growth even in more challenging conditions.

The key is identifying those with the right foundations: scalable models, strong balance sheets and clear competitive advantages. The following three companies offer a good illustration of this.

Three UK small-cap stocks for your portfolio

Quartix Technologies (LSE: QTX) provides subscription-based vehicle-tracking systems that help small and medium-sized businesses monitor their fleets, then use that data to optimise routes and improve drivers' behaviour, helping to reduce costs and improve efficiency. The appeal for customers is that installation costs are quickly recouped through fuel savings and improved productivity, creating a clear and tangible return on investment. This supports strong customer retention as well as a dependable stream of recurring revenue.

With about 330,000 vehicles already connected to its platform and a growing international presence, Quartix has established a solid base, but there is still plenty of room for growth, especially outside the UK, where adoption remains relatively low. Its scalable, cloud-based platform and reputation for reliability and customer service give it an edge in a fragmented market.

Construction may not always seem like a predictable industry, but parts of the sector are underpinned by long-term government infrastructure spending, rather than short-term economic cycles. Galliford Try (LSE: GFRD) sits firmly in that camp, operating across areas such as schools, healthcare and water infrastructure.

Much of its work is tied to regulated, multi-year investment programmes, which provide strong visibility over future revenues and a steady project pipeline. In recent years, the firm has also become more selective in the work it takes on, helping smooth earnings and control risk. It has a strong balance sheet and is well placed to benefit from investment in public services.

Applied Nutrition (LSE: APN) is a UK-based sports nutrition and health company, which produces a range of wellness products, from protein powders to supplements. The business is vertically integrated, meaning that it makes the majority of its products in-house, giving it greater control over quality and costs.

Demand from health-conscious consumers is growing and the firm's ability to innovate and secure shelf space with key retailers has been an important driver of performance. The firm is well placed to build on this momentum, supported by a scalable model and exposure to a fast-growing market.

UK small-cap stocks are neglected, but that's often when the most interesting opportunities appear. Over time, small firms tend to grow faster than larger ones. Looking beyond the headlines and focusing on companies that are steadily improving can highlight opportunities others may be missing.

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Some of the best investments are in businesses that operate in relatively unknown but essential markets, working in the background and fulfilling functions that other companies either don’t want to, or can’t afford to do themselves.

One such business is Restore (LSE: RST), the leading provider of physical and digital document-management services in the UK. It stores documents for public- and private-sector organisations, such as the NHS, and destroys old documents. There’s also a document-processing business (called Synertec), which helps companies send electronic and physical communications and a technology division (Restore Technology). All of these help the company’s customers manage their data, whether it’s on paper or in digital form.

Restore is beating expectations

In 2024, Restore generated £275 /million in revenue. The largest proportion of revenue (£170 million) came from the information management division, the one responsible for storing and managing documents. Despite the global shift over the past 20 years away from physical to digital documents, there’s still a vast and steady market for this kind of storage and Restore, as the largest operator in this area, has the economies of scale required to make it work.

The City has raised questions about the sustainability of this business multiple times over the past few decades, yet despite these concerns, the firm has consistently outperformed expectations. It’s helped that Restore has been able to move into new markets, such as operating a “digital mailroom”, which scans and digitises inbound and outbound mail for clients. It also manages exam papers and physical document processes within government agencies.

The second-largest division is a business called “DataShred”. This does exactly what it says on the tin. It’s the largest document-shredding operation in the UK, servicing tens of thousands of companies every year. The third and fourth key divisions are Harrow Green, which helps companies move office, and the technology business. Restore has found that companies moving offices need to digitise and destroy physical records, although they often choose to store old records as well. Despite this, the company agreed this week to sell Harrow Green for £5.5 million in cash to focus on the core business.

Restore's exciting potential

The technology business helps clients manage their tech assets, such as laptops and desktop computers, to ensure security throughout the asset’s life cycle. Some of its biggest clients here are public bodies, such as the Department for Work and Pensions. Restore helps the department set up new laptops, test laptops in use, and erase as well as repurpose laptops when they come to the end of their life. It can process thousands of laptops a day and has a two-week turnaround window to get each computer back into the workforce. Laptops that are not going to be repurposed for new joiners can be securely and responsibly disposed of.

This division currently accounts for just 11% of group revenue, but it has vast potential. Management has highlighted the AI product cycle, the release of Windows 11 and the beginning of the post-Covid technology refresh cycle as structural drivers for growth. The current best practice is for companies to refresh technology every three to five years. Overall, the firm has 500 active customers at present, served by 310 employees, with the capacity to refresh 13,000 assets a week.

The technology business has exciting potential over the coming years, but investors shouldn’t overlook the document side of the organisation. To bulk out this division, in March, Restore paid £33 million to acquire Synertec, which owns a proprietary software platform that helps clients communicate with their customers across different channels. Using the software, clients can upload customers’ communications to Synertec’s systems and select how they want the information to be distributed.

This can include documents printed in braille, for example, or communications sent out via text message. Synertec can turn around the client’s data request overnight, a key selling point for its largest client, the NHS, with which it recently agreed a new four-year framework set to start in the first quarter of next year. Synertec also works with clients such as P&O Ferries, Screwfix and Hotpoint.

A new direction for Restore

Despite its strengths, shares in Restore have declined by around 50% since the pandemic, even as adjusted profit before tax has risen from £23.2 million in 2020 to £34.4 million in 2024. Lack of confidence in the company’s strategy, multiple compression and general apathy among investors towards UK small caps all appear to be to blame.

However, after a change of management two years ago, the City is starting to come around to the growth story. Charles Skinner returned as CEO in 2023, after Charles Bligh, who joined as CEO in 2019, resigned. Skinner stepped down in 2019 following a decade at the helm of the group, during which time the shares returned more than 2,200%. Skinner has spent the past two years refreshing the group and its strategy, but the market is yet to factor in the changes.

According to analysts at Berenberg, the shares are trading one standard deviation below the 10-year average price-earnings (p/e) ratio of around 15; the same is true on an enterprise value to Ebitda basis. Berenberg has the stock trading at a 2026 p/e of 9.9 and a free cash flow yield of 8.3%.

Canaccord Genuity takes a similar view, with a p/e of 10 pencilled in for 2026 and a free cash-flow yield of 8.3%. What’s more, in its latest trading update, Restore reported growth ahead of market expectations, with margins returning above the medium-term 20% target, prompting a wave of analyst growth upgrades. This growth, coupled with a return to the company’s 10-year average valuation, could generate an upside of nearly 70% for the shares in the best-case scenario.

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This year marks the 30th anniversary of the launch of two competing investment trusts specialising in smaller Asian companies: Aberdeen Asia Focus (LSE: AAS) and Scottish Oriental Smaller Companies (LSE: SST). Fidelity Asian Values (LSE: FAS) was launched a year later. The long-term performance of all three has been excellent, but leadership has switched a number of times over the years.

In 2024, SST, with £380 million of net assets, led the trio and seemed set to continue its run. It had benefited from a very high allocation to India and a low one to China, but had started to shift in favour of China and Taiwan on the basis of relative valuation.

However, this shift stalled, leaving SST still with a 38% exposure to India – 10% over the MSCI AC Asia ex Japan Small Cap index – and heavily underweight Taiwan (8%) and South Korea (2%) against index weightings of 23% and 15%. These two markets have performed strongly this year, while India is still below its September 2024 peak. The result is a -10% performance over one year against 19% for AAS and 11% for FAS.

Hugh Young, who was the lead manager of AAS (£580 million of assets) until two years ago, used to say that India had terrible infrastructure but great companies, while China had great infrastructure but terrible companies and corporate governance. He also favoured Southeast Asia over Taiwan and Korea. Gabriel Sacks, who took over from him, has taken a new approach, holding just 23% in India but 18% in Taiwan and 12% in Korea.

Still, this alone does not explain his strong performance. AAS has now returned 90% over five years, which is 23% ahead of the benchmark index, 5% ahead of FAS and 24% ahead of SST. The overlap of Sacks’ portfolio with the index is just 4%, while performance has been helped by borrowings of 8% of net asset value (NAV).

Why are Asian small caps outperforming the rest of the market?

Sacks points out that “small-cap equities in Asia have outperformed the broader market over three, five and 10 years” and believes that “better diversification across countries and sectors with less concentration in a few mega caps has resulted in more market resilience”.

The key to strong future performance lies not just in a favourable economic outlook but to the potential to continue to add value from uncovering hidden gems, he argues. With that in mind, the meagre research coverage of Asian smaller companies offers an opportunity. Sacks stresses the importance of “on-the-ground expertise, first-hand knowledge and direct engagement with companies” in the process.

“Quantitative analysis is by no means guaranteed to tell us everything we ought to know,” he writes. “A business’s qualitative aspects can be every bit as influential – and maybe even more so – in guiding our choices. This is why we prefer to see things for ourselves. It is why we visit premises and facilities. It is why we meet with senior executives. It is why we enter into dialogue and ask probing questions.”

Such an approach is labour-intensive and costly, which is why many active managers focus on computer screening and index-hugging to keep charges down. This has worked over the long term, hence AAS has a 30-year annualised return of 12.2% against 5.1% for the benchmark index. Today, it looks like the obvious choice between the three trusts: it is trading on a 10% discount to NAV against just 5% for FAS and 13% for SST.

A turnaround in the Indian market would help SST, but Sacks remains cautious. “Though valuations are more palatable [than before], they are still far from bargain levels and the short-term earnings outlook appears mixed.”

That said, FAS and SST also have long-term records of clearly beating the index. So it should prove more important to be invested in one of the three than choose which one.

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My investment philosophy is grounded in diligence, discipline, and patience. At Fidelity, I benefit from a robust, on-the-ground analyst network across Asia that produces in-depth fundamental research. These insights enable me to identify good businesses led by competent and honest management teams, and to invest at valuations that offer a comfortable margin of safety. I deliberately steer clear of untested business models, highly leveraged firms, cyclical companies at peak profitability, and stocks trading at excessive earnings or cash flow multiples.

My focus is on managing absolute risk and minimising capital loss during market downturns – an approach which should help compound returns at higher rates over the long term. Consequently, the Trust maintains a contrarian, value-oriented bias, focusing on mispriced small and mid-sized businesses that have the potential to become the “winners of tomorrow” well before their strengths are widely recognised.

As bottom-up investors, we continue to uncover idiosyncratic investment opportunities across the Asian region. Here are three examples.

Three overlooked Asian stocks to consider for your portfolio

In Taiwan, we have invested in Pacific Hospital Supply Company (Taipei: 4126), a manufacturer of medical consumables. Despite being a small player, its new management is driving market share growth at a pace faster than the c.US$80 billion industry, which typically grows at a mid-single-digit rate. The business is focusing on higher-margin, more complex products and targeting quality healthcare markets of Japan, the US and Europe to drive sustainable growth. Its well-diversified customer base provides additional resilience to the business. The stock trades at 16 times its projected 2026 earnings and offers a 5% dividend yield.

In Thailand, we hold a position in Mega Lifesciences (Bangkok: MEGA), a manufacturer of generic medicines. Most of its revenue stems from ‘nutraceuticals’ or wellness drugs, with the remainder from prescription drugs and over-the-counter medicines. The company’s strong distribution network across ASEAN, together with its product pipeline and in-house manufacturing, confers competitive advantages, resulting in higher margins compared with peers. Its management is more agile and flexible than multinational competitors, enhancing its effectiveness in sales and promotions. The stock trades at 12 times its projected 2026 earnings, with a 5.5% dividend yield.

In addition, we have exposure to Hong Kong-listed Tuhu Car (Hong Kong: 9690), a Chinese vehicle-parts retailer that uses its app to direct car owners to its network of franchisee car-repair shops. It is a difficult business, but it is also light on capital and scalable, so companies that find the winning formula have high returns on capital and healthy long-term growth prospects. Tuhu is the market leader in China, where organised vehicle-parts retailing is still in its infancy. The management team is solid, and the firm should be able to grow significantly in the next 10 years. It is an early-stage company with a net-cash balance sheet, and its stock is on 15 times its earnings projected for 2026.

In an era where digital communication dominates, the enduring appeal of a handwritten card might seem quaint. Yet, for Card Factory (LSE: CARD), the UK’s leading specialist retailer of greeting cards, gifts and celebration essentials, this personal touch is the cornerstone of a surprisingly resilient business. Despite the rise of online cards, enough customers still value the sentiment of a physical card to keep Card Factory’s model relevant. Combine this with low-priced products, a repeatable purchase cycle and a remarkable recovery from the pandemic, and you have a company that’s not only surviving but flourishing.

Despite these qualities, the shares look good value too; trading on a price-earnings (p/e) ratio of less than seven – a standout bargain even among the UK’s undervalued small-cap stocks. For investors, this could be a rare chance to buy into a business with solid fundamentals and decent growth prospects at a deeply discounted price.

Card Factory is a high-street mainstay

Founded in 1997 by a Yorkshire entrepreneur as a market stall, Card Factory has grown into a high-street mainstay, with more than 1,000 stores across the UK and Ireland. It also operates an online platform, which competes with Moonpig and Funky Pigeon. Its core offering of affordable greeting cards, balloons and party supplies taps into a cultural habit that shows no sign of fading. While online platforms such as Moonpig have gained traction, particularly during the Covid lockdowns, Card Factory’s success hinges on the fact that many consumers still prefer choosing and sending a physical card. A handwritten note for a birthday, anniversary or condolence carries an emotional weight that an online printed card does not.

This preference is reflected in the numbers. The UK greeting-card market, while slow-growing, remains stable. Card Factory’s value proposition – offering cards starting at under £1 and gifts priced to suit tight budgets – ensures it captures a significant share of the market. Its vertically integrated model, with in-house design, printing and warehousing, keeps costs low and margins healthy.

Card Factory’s business model is uniquely suited to weather economic storms. Its low-price goods are affordable even when household budgets are squeezed. The repeatable nature of its products, tied to recurring occasions such as birthdays, Mother’s Day and Christmas, ensures steady demand regardless of the economic climate. Unlike discretionary retailers selling big-ticket items, Card Factory benefits from consumers’ reluctance to skip small, sentimental purchases, even during downturns. This resilience was evident in the firm’s performance during recent economic challenges.

While rising energy costs, freight inflation and National Living Wage increases have pressured margins, Card Factory has offset these through targeted price increases and tight cost control.

Card Factory's remarkable dividends

The only time Card Factory genuinely faltered was during the Covid pandemic, when high-street footfall plummeted. The company took a brutal hit. Dividends have been a hallmark of Card Factory’s shareholder-friendly policy since its 2014 flotation, but they were suspended during the pandemic.

The recovery coincided with a return to normality. By 2023, sales had surpassed pre-pandemic levels. Store transaction volumes, while still below pre-pandemic levels, have rebounded strongly, driven by high-street footfall and click-and-collect services. Online sales, although slightly down post-reopening, remain significantly ahead of pre-pandemic figures, reflecting a lasting shift in consumers’ behaviour. Most tellingly, Card Factory reinstated its dividend in 2024, declaring an interim payout for the first time in five years, a clear signal of confidence in its cash flow and long-term outlook.

Despite this turnaround, Card Factory’s shares remain extraordinarily cheap for a business with stable revenues and reinstated dividends. Even in a UK market brimming with undervalued small-cap stocks this valuation stands out and, with a high dividend pay-out, investors earn a return even while waiting for the market to wake up to the potential.

Card Factory’s growth prospects add to its appeal. The firm is expanding, with new openings planned, and it is enhancing its online platform. A recent $25 million acquisition of Garven, a US-based card retailer, signals ambition to tap the potentially lucrative US market, although investors are watching closely for its financial impact. Partnerships, such as with Aldi, and a focus on higher-ticket items such as balloons and party supplies, are expected to drive revenue growth of 5%-7% annually over the next few years.

No investment is without risks. Card Factory’s reliance on physical stores makes it vulnerable to shifts in consumers’ behaviour.

Inflationary pressures, especially in freight and labour, could continue to squeeze margins, and the company’s debt pile, while manageable, requires careful monitoring. Yet these risks seem more than priced into the current valuation. With a strong cash flow and a diversified revenue stream, Card Factory is well-positioned to navigate challenges. Its ability to outperform competitors in key trading periods, such as Valentine’s Day, underscores its market strength.

Card Factory may not be glamorous, but its resilience makes it a compelling opportunity. Its recovery from the pandemic has been robust, with revenues above pre-pandemic levels and dividends back on the table. Trading at a historically low valuation, with decent forecast growth, the shares are a bargain in a market full of cheap stocks.

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When Beauty Tech Group made its debut on the stock exchange earlier this month, it was a welcome boost for the UK market, which has struggled to attract new issues in recent times. The £300 million listing was also a big win for venture-capital trusts (VCTs) – three VCTs run by Mercia Fund Management were among the first investors to recognise Beauty Tech’s potential, taking stakes in the company in 2018 when it had annual sales of less than £1 million and was still losing money. Beauty Tech follows in the footsteps of other VCT success stories, including Zoopla, Gousto and Virgin Wines.

VCTs were launched 30 years ago this year by the then chancellor Ken Clarke with a mandate to encourage investment in early-stage British businesses. Clarke’s view was that investors needed encouragement to risk their money in these small and immature companies, where the danger of failure is a very real one. He therefore legislated for the launch of VCTs – collective funds that build portfolios of such companies, but offer a series of generous tax reliefs to compensate for the additional risk, providing some downside protection in the event of losses. Successive chancellors have fiddled with the reliefs along the way, but the basic premise has been maintained. Today, investors who buy new VCT shares get 30% upfront income tax relief – so a £10,000 investment, say, costs only £7,000 – and enjoy tax-free dividends with no capital-gains tax to pay on profits. In addition, you can put up to £200,000 a year into VCT shares – far more than you’re allowed to invest in other tax-efficient wrappers, such as private pensions and individual savings accounts (ISAs).

The critical phrase is “new VCT shares”. While shares in VCTs are listed on the stock market, providing useful liquidity for investors who need to sell, it’s only subscriptions for new shares that attract the 30% income-tax break; investors must also hold on to the shares for at least five years, or face demands to repay the relief. In practice, this means that VCT managers offer new shares each tax year – either by launching new funds, or through additional fund-raisings for existing vehicles. This tax year about 20 VCTs have launched new share issues, or signalled that fund-raisings are imminent – and Alex Davies, the founder of investment platform Wealth Club, thinks this is just the beginning. “With the launch of the big name VCTs, such as Northern and British Smaller Companies, VCT season has only just begun,” Davies says. “So far, demand looks robust, with these VCTs respectively raising £12 million and £18 million in their first days of opening. With signs of life in the initial public offering (IPO) markets, which should be good for VCT exits, and further tax rises likely in the Budget, this year should see another year of healthy demand for VCTs.”

The Budget reference is a significant one. In recent years, VCTs have captured investors’ attention in an environment where other tax-advantageous savings schemes have been squeezed. Reduced private-pension contribution allowances for wealthier savers, for example, appear to have boosted the sector. The move to make unused pension assets subject to inheritance tax is also piquing interest in VCTs; although they offer no inheritance-tax benefits of their own, the funds are subject to fewer withdrawal restrictions than pension products and are hence useful for financial planning. Demand has boomed accordingly. “Despite a difficult economic background, the 2024/2025 tax year was the third-best year for VCT fundraising,” says Annabel Brodie-Smith, communications director of the Association of Investment Companies. “In the current environment, dominated by daily headlines about the need to raise taxes, it’s not surprising that VCTs remain a favoured investment for those who want to back growing UK companies while reducing their tax bill.”

Are VCTs right for you?

Last year’s VCT fund-raisings totalled £845 million, some way behind the £1.13 billion and £1.08 billion achieved by the sector in 2021-2022 and 2022-2023 respectively. Nonetheless, Chris Lewis, chair of the VCT Association, says the scale of the figure reflects widespread support for the sector. “More than ever, we see entrepreneurs, investors and policymakers aligned on the need to support the high-growth, high-potential firms backed by VCTs.” Clearly, this year’s VCT managers spy an opportunity given speculation about more tax rises to come in next month’s Budget. Several are even offering discounted fees to early birds. But while it’s true that the most popular VCTs tend to sell out relatively quickly – funds limit the amount they raise so that managers aren’t left scrambling to find enough attractive small businesses in which to invest – advisers urge investors to be cautious. VCTs aren’t suitable for everyone. They’re generally a better fit for those who have already made good use of private pension and ISA reliefs – and you’ll need to be comfortable with risk and volatility.

Even if you’re relaxed about risk, a question mark remains. The average fund has delivered a 53% total share-price return over the past decade. While the effective value of that return is boosted by the upfront tax relief, it’s worth putting it into context. The average investment trust investing in UK-listed companies rose 112% over the same period; the average investment trust with exposure to global shares delivered 280%. Choosing the right vehicle is critical. Over those 10 years, shareholders in the best-performing VCT enjoyed total share-price returns of 168%; those in the worst performer lost almost 80% of their money.

Many VCT managers are focused on income rather than capital gains. The average VCT yields 6.9%, with managers often structuring their funds so the proceeds from successful exits from portfolio companies can be used to pay dividends. That 6.9%, remember, is tax-free, making the yield look even more attractive given current low interest rates. Still, Ben Yearsley, director of adviser Fairview Investing, worries VCTs may have become victims of their own success. “Too much money has been raised in the past few years and it is chasing too few high-quality companies,” he warns. “I think investors will need to get used to returns in the region of 5% each year and not the 7%-8% seen previously. Is this enough for the risk? You’ll need to make your own mind up, but without the tax breaks, the answer would definitely be no.”

Yearsley also points out that the challenges – and risks – involved with managing VCTs have grown due to recent tweaks in the rules. Most significantly, the funds are usually now banned from investing in any business that has been trading for more than seven years – limiting them to less-mature enterprises at an earlier stage of growth. That’s in addition to restrictions such as investee companies having to be worth less than £15 million and with fewer than 250 employees. VCTs must also invest 80% of funds raised in qualifying assets within three years.

“I’m still not convinced that VCT managers have transitioned totally successfully to the new, more restrictive rules that mean only younger high-growth companies can receive investment,” Yearsley adds. Brodie-Smith is more optimistic. “In a challenging landscape, VCTs are helping to get ambitious businesses off the ground, and many of these will go on to fuel growth in the UK economy,” she argues.

VCT options

It’s also worth pointing out that VCTs come in several different shapes and sizes, with different risk profiles in each case. The largest section of the market is accounted for by generalist VCTs that invest in privately owned qualifying companies in a wide range of sectors, providing some diversification benefits. There are also specialist VCTs, which focus on one sector of the market – technology or healthcare, for example – and are therefore more exposed to the fortunes of a narrow band of businesses. In the third category, Aim VCTs invest in shares issues by companies listed on the junior market. Although Aim constituents are listed companies, rather than privately owned businesses, some still qualify as VCT investments because of their size and age. These Aim VCTs have performed less well, on average, than other VCTs, delivering only 20% over the past 10 years – but with much less variability.

These variations on the theme at least present investors with plenty of options – and the potential to build a portfolio of VCTs over time. It’s a good idea to begin with a base of generalist VCTs, only adding exposure to more specialist vehicles later on. The key is to do plenty of homework first – or to consult an independent financial adviser with expertise in this area. As Budget speculation continues and some VCTs start to fill up, it may be tempting to rush into a decision for fear of losing out at the hands of the chancellor or other investors. But don’t part with your money unless you can build an investment case for doing so that makes sense in the context of your existing portfolio, your financial goals and your attitude to risk. Tax incentives alone aren’t a good enough reason, in isolation, to embrace VCTs.

Three VCTs to consider now

For investors ready to take the plunge into the VCT market, choosing the right vehicle from the 20 or so funds raising money is vital. We asked Alex Davies of Wealth Club to pick his favoured funds for 2025-2026. Here are his three top picks.

Northern VCTs: “These long-standing VCTs [manager Mercia is raising money for Northern Venture Trust, Northern 2 VCT and Northern 3 VCT] target more established companies with growth potential. Mercia’s sweet spot is regional businesses – more than half the portfolio is outside London and the southeast – in the healthcare and technology sectors. This is an area where Mercia is getting success after success. The latest example is beauty technology firm Beauty Tech Group, which floated at the start of October at a £300 million valuation.”

British Smaller Companies VCTs: “The British Smaller Companies VCTs [British Smaller Companies VCT and British Smaller Companies VCT 2] target business-services companies – a pretty large pond to fish in. The current catch includes some cracking companies, such as financial adviser review platform Unbiased, which is expanding rapidly in the US, and digital special-effects studio Outpost VFX, which has worked on Captain America and Rings of Power.”

Triple Point Venture VCT: “Triple Point aims to invest earlier in a company’s life than many VCTs. At this stage there’s less competition, resulting in lower valuations and potentially higher returns. It is also higher risk, but the VCT mitigates that by making lots of smaller bets before doubling down on the winners. We think this VCT offers investors a distinctive, well thought out approach – with a manager who is starting to develop an appealing record.”

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Small cap stocks can be a promising source of growth in your portfolio. But they are hard to pick, and unpredictable.

That said, small caps are having a moment. Taylor Wimpey (LON:TW.) was the second-most-bought stock for DIY investors on Interactive Investor in August, despite being a FTSE 250 constituent with a market cap of less than £3.5 billion.

The Russell 2000, an index of US-based small cap stocks, hit a new all-time high of 2,488 on 23 September. Over the preceding three months, the index’s gains of 15.6% outpace those of its large-cap cousin, the S&P 500, which gained 10.5% over the same period.

The small-cap index’s surge has been underpinned by a rare run of upward earnings revisions, said Lale Akoner, global market analyst at eToro. “Falling financing costs are a key fundamental driver for the performance, with interest expenses now at their lowest in over a year. With markets pricing in further Fed cuts, smaller companies that rely heavily on short-term debt stand to benefit most,” said Akoner.

“On top of that, fiscal support via the ‘One Big Beautiful Bill’ could inject $150bn into U.S. households from 2026, boosting consumer-sensitive small caps such as homebuilders, retailers and restaurants,” Akoner added.

I’ve written recently on why growth-focused investors may want to look at UK small caps, but looking more broadly, there is plenty of reason to consider investing in global small caps right now.

The trick is knowing which ones to pick.

What to look for in a small cap stock

The challenge when investing in small cap stocks is that, as an asset class, they’re not brilliant.

“Our contention has always been that smaller companies as a whole are pretty low quality,” says Bill Chater, global small cap investment specialist at Baillie Gifford.

This might sound controversial from someone with his job title, especially considering he is part of the team at Edinburgh Worldwide (LON:EWI), an investment trust which focuses on global small cap and private companies. But Chater’s point is that the art of investing in small caps is the ability to spot those small companies with the greatest potential: the ones that could become the large caps of tomorrow.

“We want to look for individually outstanding companies – companies that are immature compared to their ultimate market opportunity,” he says.

There are four factors that Chater and his team look for when selecting small cap investments with this potential:

• Innovation, to solve a large problem (which could be addressing a significant market opportunity or developing a new market around their solution)
• Establishing a competitive advantage that deepens over time
• The quality of the management team, with an emphasis on founder-leaders rather than professional CEOs
• Scalability – the potential of the solution they are developing to expand to new heights.

Chater adds that, even though he is a growth investor, valuation is a key factor that he never loses sight of.

“You want to buy a business when it’s relatively cheaply valued, hold it for a period of time, and then sell it when it’s worth more,” he says. As a rule of thumb, Chater and the EWI team are looking for companies that they can realistically see doubling their value as a base case.

How to invest in global small caps

Even the experts find it hard to pick small caps that will reliably turn into mid- or large-cap stocks in the future.

“It’s not necessarily about being right with every investment,” says Chater. “It’s about finding a few special businesses and then being very right with them.”

So if you are managing your own investments, without access to the depth of research that Chater and similar teams have available, it could be wise to outsource the stock picking to small cap experts by investing in an investment trust or a fund.

The average investment trust in the AIC’s global smaller companies universe currently trades on a 12.1% discount (as of 26 September 2025). EWI currently trades at a discount of approximately 7.0%. Other small cap investment trusts trading at narrower discounts than the sector average include Herald Investment Trust (LON:HRI) and Smithson Investment Trust (LON:SSON).

You could also opt for a passive approach to investing in small cap stocks. The Invesco Russell 2000 UCITS ETF (LON:RTYS) tracks the Russell 2000 index of smaller-capped US stocks. Alternatively, for access to global small caps, you could use the HSBC MSCI World Small Cap Screened ETF (LON:HWSS) which tracks the the MSCI World Small Cap Selection Screens Index (whilst integrating ESG metrics).

Remember, though, that passive approaches like these amount to “owning the asset class”, which Chater prefers to avoid in favour of a smaller number of high-conviction small cap stock picks.

At Odyssean Investment Trust we seek to invest in high-quality UK businesses trading below their fundamental value, with scope for that value to grow through proactive management action. One area where we have been active recently is an unglamorous part of the market: British small-cap industrials.

The UK industrials sector is overlooked and unloved. Investors often conflate “industrials” with visions of grubby metal bashers serving a diminishing manufacturing base. In truth, this sector is highly diverse, and for those prepared to look, you can find a number of first-rate, globally-focused businesses with exciting growth prospects.

To find the gems in industrials, we look for three key attributes. First, the most attractive companies utilise their own intellectual property in their products or production processes, allowing them to be global leaders within a niche. Expertise that is hard to replicate creates a significant economic moat to underpin any investment.

Second, while industrials can be cyclical, many companies enjoy exposure to long-term growth megatrends such as AI spending, renewables investment or growing demand for healthcare. Short-term swings can often hide longer-term secular stories, offering opportunity for the patient investor.

Finally, industrials businesses can be complex: managing production, ongoing research and development (R&D) and an evolving demand environment are not easy. High quality management can add significant value; backing proven, experienced teams is crucial.

Three British industrial stocks that are powering profits

XP Power (LSE: XPP) fits our criteria nicely. The business is a leading designer and manufacturer of power supplies that enable high-technology applications across industrial, healthcare and semiconductor end markets. It uses its world-leading expertise to design power supplies that meet the needs of the most demanding cases.

The group has a strong track record across the cycle, benefiting from growing demand for semiconductor-manufacturing capacity – a trend set to continue given current geopolitical and AI demand drivers. Led by a proven team who have delivered strong operational control through the recent cyclical downswing, this stock’s long-term potential is overlooked by the market.

Another emerging UK industrials champion is Xaar (LSE: XAR). The company manufactures ink-jet printheads with unique technology that allows the deposition of high viscosity fluids at high accuracy for a range of industrial applications. Based on intellectual property developed over many years, the group’s print heads are sold globally and are the core component of its customers’ printing machines.

The group is active in a number of sectors, but under its current leadership has recently used the unique abilities of its technology to open up markets previously unaddressed by ink-jet deposition solutions. These new opportunities offer a route to long term growth regardless of shorter-term market cycles and, we believe, herald an exciting future for the company.

Another UK-based industrial with a niche, global leadership position is Dialight (LSE: DIA), a leading provider of LED lights used in hazardous industrial environments. The group’s design expertise allows it to offer industry-leading reliability, critical for the extreme, niche-use cases it serves.

LED lighting continues to gain share from traditional alternatives given its higher reliability and lower power usage, providing a tailwind of growth for the group across economic cycles. After a tough period, Dialight has been rejuvenated in recent years under a new leadership team with proven experience of driving value at industrial businesses. We believe it is one more of the gems in UK small-cap industrials.

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Managers of open-ended funds must carefully consider the liquidity of their holdings, because they may need to sell assets to meet redemptions. Since small and mid-sized companies are less liquid than larger companies, this means that most open-ended funds will often be quite restricted in how much they can invest in smaller-cap stocks. Some of the best companies are out of reach of most open-ended funds.

This is a key advantage of investment trusts when investing in sectors such as this. Investment trusts don’t run the same risk of having to sell assets in a hurry because investors are suddenly pulling their money out. That enables them to take a longer-term and more value-oriented view.

Core choices in the investment trusts sector

So what are some of the core options in the sector? The largest small- and mid-cap trust, with £2.2 billion in assets under management (including gearing of 14% at present), is Mercantile Investment Trust (LSE: MRC), managed by JPMorgan. The trust has a five-year total return in net asset value (NAV) terms of 10.6% per year – 0.9 percentage points ahead of the FTSE All-Share, excluding FTSE 100 stocks and investment companies. It has also beaten its benchmark over three years and 10 years. The discount to NAV is 10%.

The largest trust focused on small caps is Aberforth Smaller Companies (LSE: ASL), with £1.4 billion in assets, and gearing of just under 3%. It also trades on a discount to NAV of 10% and portfolio valuations offer a further discount – its holdings trade on a price/earnings ratio of seven times forecast earnings, 22% below the average for its investment universe. The NAV return over five years is 14.7% per year.

Henderson Smaller Companies (LSE: HSL) employs a growth at a reasonable price (Garp) strategy, focusing on high-quality companies with strong balance sheets and competitive market positions. The long-term return has been strong, with NAV total returns of almost 12% since November 2002, when joint manager Neil Hermon – who retires this month – was appointed. However, performance has deteriorated in the past five years, with a return of 5% per year. Gearing is 13% at present, and the discount to NAV is slightly under 9%.

Income investors could look to JPMorgan UK Small Cap Growth & Income (LSE: JUGI), which adopted a new dividend policy following the merger of JPMorgan’s mid-cap and small-cap trusts last year. The trust now pays quarterly dividends totalling 4% of end-July NAV each year. This requires a quality focus: the portfolio has a free cash-flow yield of 8.5% (compared with the index’s 5.5%) and a return on invested capital (ROIC) of 15% (against 9% for the index). The five-year NAV return is 9.5% per year. Gearing is around 8% and the discount to NAV is 7.5%.

Investment trusts for focused portfolios

Odyssean Investment Trust (LSE: OIT) and Rockwood Strategic (LSE: RKW) are worth considering for focused portfolios. Both are run by managers at Harwood Capital, but with different approaches: Rockwood is keener on smaller stocks and recovery plays.

Odyssean’s top four holdings make up more than half its portfolio. More than 10 of its holdings have been taken over since it launched, often at a significant premium. The five-year NAV return is 8.5% per year and the discount to NAV is 6.5%. Rockwood’s top 10 holdings make up 60% of the fund, which has returned roughly 21% per year over five years. The shares often trade at a premium (currently 1%).

Rupert will be hosting an evening event on UK investing in association with Law Debenture on Wednesday, 17 September in London and online. Go to lawdebenture. com/events/winstar-wideninginvestor-networks for details.

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The Global Smaller Companies Trust seeks to offer investors exposure to small businesses both in the developed markets and faster-growing emerging markets. The trust takes a long-term, conservative approach to investing in good-quality, growing businesses when they become available at a significant discount to intrinsic value.

This disciplined investment process focuses on capital preservation and long-term value creation rather than chasing short-term market trends. We have found exciting opportunities in companies likely to benefit from increased spending on construction, both in the public and private sectors.

Three small companies to invest in

Martin Marietta Materials (NYSE: MLM) is a US-based producer of construction materials, such as aggregates, cement and ready-mix concrete. As the business sells products that have a low cost-to-weight ratio, it effectively operates a series of local monopolies. Materials from the company’s quarries are rarely transported more than 50 miles owing to high transportation costs. The business has a history of raising prices for customers, even in difficult times.

The company’s infrastructure division is likely to see significant demand from the $1.2 trillion Infrastructure Investment and Jobs Act (IIJA) that was passed in 2021. Spending on manufacturing and data-centre facilities and a recovery in construction of single-family homes are also longer-term drivers of organic revenue and profit growth for Martin Marietta. The company benefits from a strong balance sheet and prudent capital allocation, which provides resilience in more challenging market conditions.

Breedon Group (LSE: BREE) in the UK is a similar business. It has exposure to Britain and Ireland and recently entered the US through an acquisition. Construction activity in the UK and Ireland has not yet recovered to levels last seen in the early 2000s, and therein lies the opportunity. From a supply perspective, permitting for new assets is very challenging and this keeps industry capacity tight, reinforcing the company’s ability to raise prices.

Management has a history of creating shareholder value from acquisitions, through implementing the industry’s best practices at the operations of acquired businesses. The company is likely to make further purchases of smaller competitors. There is ample scope for further purchases, especially in the US. Share ownership by insiders is high, aligning management with shareholders.

Canada’s WSP Global (Toronto: WSP) offers engineering services in the areas of transportation, infrastructure, environment, property and power. The company has grown its market share organically by offering a full suite of services to its customers, making it a “one-stop shop”.

WSP’s global footprint and strong relationships with clients also help it to secure repeat business and large-scale contracts, adding to the predictability of its revenue streams. The business has natural drivers behind it in the form of an aged infrastructure base that needs updating, urbanisation, climate change and water scarcity. It supplements this growth through opportunistic acquisitions that bring additional capabilities to the business.

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There is an interesting change taking place in global equity markets. Investors are shifting their focus from US equities towards global stocks. Emerging markets are leading the charge, but demand for other regions is growing too. The trend is partly a result of valuation. Last year, the valuation premium of US versus international equities reached more than “three standard deviations over the long-term average since 1970”, says Steve Nguyen, fundamental portfolio manager at US investment management group Causeway Capital.

“Even with the underperformance of US vs. international this year, the US valuation premium is still around the two standard-deviation level.” After 17 years of lacklustre performance, European equities, as measured by the MSCI Europe index, are extremely discounted relative to their US counterparts (using the MSCI USA index as a benchmark). They are on a two-year forward price/earnings (p/e) ratio of 13 (MSCI Europe) compared with 21 for the US index.

Within emerging markets, the gap is even wider. Since the beginning of 2021, they’ve underperformed developed market equities by 55%, says JPMorgan. Go back to 2010, and the gap widens to 200%. Much of this is due to China’s performance, or rather lack of it. However, JPMorgan has observed a broadening participation in Chinese equities beyond the country’s world-leading tech sector. There are still plenty of clouds hanging over China’s economy, but policymakers are starting to shift away from regulation towards stimulating the domestic economy.

As a whole, according to JPMorgan, emerging markets are trading at one standard deviation below the 20-year average, relative to developed markets. There has been only one other occasion when they have been this cheap: after 2000, when Asian financial markets were still recovering from the double whammy of the 1997 Asian financial crisis and the dotcom bust. On a price-to-book basis, emerging markets are trading one standard deviation below the 30-year average at 0.5 of book value, the lowest level since 2000 (in 1997-1998 the ratio fell to 0.3).

Emerging markets are both cheap and under-owned, according to analysts. That implies scope for a recovery in both sentiment and valuation. JPMorgan’s team likes India, Korea, Brazil, the Philippines, the UAE and Greece. The latter is an interesting play. The bank notes that investors can book a 10% shareholder yield from the country’s formerly distressed banks, while the economy is also set to grow by 2% this year, with tourism offsetting any tariff hit.

Finding value in global equity markets

The valuation story is highly appealing in international markets. Martin Connaghan, co-manager of Murray International Trust (LSE: MYI), notes that there is “compelling valuation support in Europe and emerging markets, particularly in Latin America and Asia”. He adds: “Investors can still access many of the same structural growth themes found in the US, but at significantly lower valuations.”

While some countries may now look as if they’re heading for turbulence as a result of Donald Trump’s trade war, the reality is more nuanced, says Connaghan. “[Consider] the nature of the business. For example, while India may face high tariffs on physical goods, IT services firms such as Infosys or Tata are less directly affected. Their offerings, such as software, cloud and consulting, aren’t subject to the same tariff structures.”

Small caps present another opportunity for investors. Over the past five years, small caps have faced the same macroeconomic headwinds as large caps, but have still delivered fairly robust returns. The MSCI International Small Cap index has outperformed the MSCI International index (both ex-US) by 250 basis points annually.

“Smaller companies tend to be more domestically focused, which can insulate them from some of the cross-border complexities,” says Connaghan. And while international small caps have traded at a premium to international mid and large caps over the past 20 years, the current valuation is at a slight discount, says Nguyen.

Meanwhile, US management teams used to be far ahead of their international counterparts when it came to deploying buybacks. But recently there’s been an increase in buybacks in regions such as Japan, Europe and the UK. As a result, total shareholder return yields are now often “significantly higher outside of the US [while] the UK total yield is now more than double that of the US,” he adds.

An example is Italian financial services provider Intesa Sanpaolo. Recently added to Murray’s portfolio, Intesa is the number-one domestic bank in Italy. It has a common equity Tier 1 capital ratio of 14%, a cost-to-income ratio of below 40% and a dividend yield of 7%. In addition to Murray International, some of the best trusts to play global value are the Scottish American Investment Company (LSE: SAIN), which has an 86% allocation to global equities with the remaining allocation to infrastructure, bonds and real estate. STS Global Income and Growth (LSE: STS) and JPMorgan Global Growth and Income (LSE: JGGI) all offer dividend yields of between 3% and 4%.

In the global small-cap sector, region-specific trusts have produced the best returns over the past decade. Options include the European Smaller Companies Trust (LSE: ESCT), which has outperformed its sector by 41% over the past five years, or the JPMorgan US Smaller Companies Investment Trust (LSE: JUSC), which has outperformed the small-cap benchmark Russell 2000 index by 0.5% per annum over the past decade. For a play on Japan, consider the Nippon Active Value Fund (LSE: NAVF).

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UK equities are not a fashionable buy, but they might be a good one. Small caps in particular are trading at a significant discount, based on Morningstar data, and a shifting economic environment could give them a boost.

The research company’s analysts believe UK small caps are trading 30% below their fair value. Given the company doesn’t cover every area of the market, it points out that individual stocks could be even more undervalued.

A “series of unfortunate events” has brought this situation about, including Brexit, Covid-19, and a period of high inflation and interest rates.

Public market investors have taken fright and pulled money out of the sector, with Morningstar reporting 14 quarters of consecutive outflows. Assets have plummeted to a 10-year low, down 62% from their post-Covid peak in 2021.

They are not being shunned by private equity investors, though, who have taken the opportunity to bag a discount in bargain Britain. In 2024, one in 20 of all UK listed companies was put under offer publicly, according to investment bank Peel Hunt.

In a report published at the end of last year, the bank warned that up to a third of firms on London’s junior market could be vulnerable to a takeover in 2025, as buyers look to take advantage of discounts in the small cap space.

“Depressed stock prices create a ripe environment for takeovers, and we’ve seen these coming at significant premiums on average,” said Joseph Hill, senior investment analyst at investment platform Hargreaves Lansdown.

He notes that the average takeover in the UK equity market in 2024 came at a “whopping 44% premium”. This begs the question, should retail investors take their lead from institutional buyers and be more bullish on the UK?

“At current undemanding valuations, there’s an opportunity for investors to add excellent long-term growth potential to their portfolios,” Hill added. “Smaller companies tend to be under-researched too, which creates lots of opportunities to uncover hidden gems.”

UK equities: could this time be different?

UK equities have been unloved since Brexit, but the market hasn't yet caught up. Some valuation-focused investors will be running out of patience. Why should this time be any different – and are small caps a good angle to play?

Firstly, a shifting monetary policy backdrop could prove supportive for the asset class.

Small caps generally struggle during periods of high inflation and interest rates, as they are less able to absorb higher costs and are often more leveraged than their large-cap counterparts.

Combined with regional challenges, this has created a double-discount when it comes to UK small caps. However, inflation has now slowed considerably from its peak, and interest rates are on the way down.

Increasingly, events across the pond are challenging the narrative of US exceptionalism too. So far this year, the main European and UK stock market indices are leaps and bounds ahead of the S&P 500, which has suffered from trade uncertainty.

A similar trend can be seen in small caps. Although the FTSE Small Cap Index is up less than 1% so far this year, the Russell 2000 (a US small cap index) is down more than 7% over the same period.

If investors start to reduce their allocation to the US, UK companies of all capitalisations could feel the effects.

Darius McDermott, managing director at research agency FundCalibre, notes that 19 of the top 20 contributors to global equity returns over the past decade were US companies. The Magnificent Seven alone drove 50% of MSCI World gains over the past two years. This dominance is now under threat.

“More and more pension funds are questioning their US exposure, and we could therefore be on the brink of a cataclysmic shift in global markets. Few will exit the US entirely – nor should they – but people always underestimate the power of technical flows,” McDermott said.

“If even a small slice of global pension money is reallocated into listed UK equities, it could have a tangible impact – especially for UK small caps, where even minor shifts in institutional flows have the potential to be transformational.”

Domestic factors could help improve the environment for UK small caps too. Under the Mansion House Accord, workplace pension providers have committed to invest 10% of their default funds in private markets by 2030, with at least half of this going to the UK.

Despite being public-market assets, UK shares listed on the Alternative Investment Market (AIM) are included. The government believes this will channel £25 billion into UK assets overall.

On its own, the policy is unlikely to turn things around for the junior market, which has suffered takeover activity, a lack of initial public offerings, and tax changes in recent years. However, it does bring some much-needed good news to an important part of the small cap universe.

Recent trade deals could also boost investor sentiment when it comes to UK equities.

Three UK small cap funds to consider

Both Hargreaves Lansdown and Morningstar highlight the Artemis UK Smaller Companies Fund as one that could be worth considering.

The managers won’t invest in companies that are pre-revenue, because they have a strong focus on cash generation. “They’re also sceptical about investing in small businesses with very ambitious growth expectations,” Hill notes.

For this reason, the fund may lag growth-oriented peers in a rising market but could prove more resilient in periods where markets fall.

Another fund which could be worth a look is the WS Gresham House UK Smaller Companies Fund, which Morningstar recently added to its prospects list.

Morningstar says the fund employs “a private equity mentality to investing in UK small caps and mid caps”. Top 10 holdings include companies like Everplay, the games label developer, and Moonpig Group.

Both funds have delivered top quartile performance over the one, three and five-year performance periods.

Those who prefer passive exposure could consider the iShares MSCI UK Small Cap ETF. UK small cap ETFs are hard to come by, meaning this is the only real option on the market if you want a passive fund.

It tracks over 200 small cap companies in the UK and comes with an ongoing charge of 0.58%.

UK small caps are a hot pick among many stock market experts.

Many of the most popular stocks tend to be large caps, but there is a strong case to be made for the higher growth potential of smaller companies.

UK smaller companies have been labelled the most unloved stocks in the world. But Annabel Brodie-Smith, communications director of the Association of Investment Companies (AIC) argues that this is partly down to a lack of understanding.

“Smaller companies are far less researched than large caps,” she says. “Investment trust managers are well placed to spot future winners. They spend their days scrutinising the business and its competitors in addition to meeting the management face-to-face and asking questions before they commit any money.”

The AIC has compiled research on the most popular companies among 22 investment trusts it represents that specialise in UK small caps.

The results show that four companies in particular stand out among UK small cap investment trust managers. Three of these are selected by a large number of trusts, with the fourth demonstrating the highest amount of investment value of assets held by UK small cap investment trusts.

What are the most popular UK small caps?

Among investment trusts that focus on UK small caps, here are the 14 most popular holdings.

^{Source: theaic.co.uk / Morningstar (based on latest available portfolio information as at 09/05/25). Shows all companies held by at least six trusts in the AIC UK Smaller Companies sector.}

The three most popular in terms of the number of trusts that hold them are XP Power, 4imprint Group and Alpha Group International.

4imprint (LON:FOUR) was founded in the US but is now headquartered in London. A FTSE 250 constituent, it has operations in Canada and Ireland as well as the UK and US. It is a direct marketer of promotional merchandise, “the market leader in promotional gifting in the USA” in the words of Georgina Brittain, co-manager of JPMorgan UK Small Cap Growth & Income (LON:JUGI).

“Currently buffeted by concerns over the US economic environment and the potential tariff impacts, we expect 4imprint to prove itself a long-term winner, as it has in the past,” Brittain adds.

As of 31 March, Alpha Group (LON:ALPH) was JUGI's fifth-largest holding, with 3.09% of the portfolio. It describes itself as "both fintech and consultancy", providing solutions across FX risk management, global accounts, mass payments and fund finance.

XP Power (LON:XPP) builds and distributes power supplies and converters for businesses in the healthcare, semiconductor and industrial technology markets.

Indriatti van Hien, co-manager of The Henderson Smaller Companies Investment Trust (LON:HSL), likes the guaranteed revenue streams the company gets when it signs up new clients.

“Once they receive product approval from clients, there is an annuity-like revenue stream for the lifetime of the customer’s equipment, which is typically five to seven years,” she says.

“Their equipment is incorporated into a well-diversified range of products, including surgical robots, advanced semiconductor fabrication technology and analytical test instruments, all of which are sectors with long-term growth prospects,” van Hien adds.

UK small cap investment trusts’ favourite stock by asset value

While those three companies are held by the highest number of trusts, they don’t have the highest net value of assets held by UK small cap investment trusts.

That accolade goes to XPS Pension Group (LON:XPS). Though only held by six of the trusts in the AIC’s sample of 22, those six held a combined £93.06 million in assets. While the eight trusts holding XP Power had an average stake of £7.5 million, those holding XPS Pension had an average stake nearly twice as large, at £15.5 million.

XPS Pension is a pensions consultant. “We believe that the company is well positioned to benefit from regulatory changes necessitating increased demand for advice from pension schemes,” says Brittain, one of the managers backing the company.

“In addition, XPS is benefitting from the huge growth in the pension risk transfer market, as a very large number of defined benefit pension schemes that are in surplus look to transfer the risk to insurers,” Brittain adds. She also highlights that its recent acquisition of Polaris Actuaries and Consultants gives it a roadmap towards further growth via the insurance consulting market.

Why are investment trusts a good vehicle for small cap investing?

Investment trusts are active funds, meaning that they have a professional manager (or team of managers) selecting their holdings. As Brodie-Smith highlights, that means the individuals running an investment trust can really get under the hood of their investments, particularly smaller companies.

The investment trust model is particularly well-suited to investing in relatively illiquid assets like small caps.

“Investment trusts are particularly suitable for investing in smaller, less liquid companies,” explains Brodie-Smith. “Their fund managers are able to take a long-term view of their portfolio because they are never forced sellers."

This is because investment trusts are closed-ended funds; they have a limited number of shares created at their inception, and these shares then trade on stock exchanges independently of the assets they hold.

That does mean that investment trusts can trade at a discount or premium to their net asset value (NAV). This is in contrast to open-ended funds like exchange-traded funds (ETFs).

UK equities have been unfashionable for the best part of a decade. Valuations suffered as a result of the Brexit referendum in 2016. Since then, limp economic growth and a preference for the tech-heavy US market have compounded the problem.

The domestic market has also suffered as private investors have diversified away from UK equities to adopt a more global approach. Just 4.4% of UK pension assets are now held in domestic equities, according to think tank New Financial. This is a historic low. The global average is 10.1%.

The silver lining of this particular cloud is that it has created valuation discounts for bargain-hunting investors. Those who are patient enough to wait for a rerating could potentially reap meaningful rewards.

Research from global investment company Abrdn suggests UK smaller companies offer particular opportunities, trading at a discount of more than 24% compared to their 10-year average. This is the widest discount of any region.

Small cap valuations have suffered in recent years thanks to a period of high inflation and interest rates. It can be more difficult for small companies to swallow price increases, and they are often more leveraged (and more exposed to floating-rate debt) than their larger counterparts.

This has created a double discount in the UK small cap market, with regional and sector-specific factors colliding.

Smaller companies globally are trading at a 3.2% discount, according to Abrdn, but this widens significantly to 24.3% among UK small caps. This is despite the fact that UK small caps are forecast to grow their earnings by 10% over the next year, according to recent Factset data.

“These discounts reflect the negative sentiment that we’ve seen towards UK smaller companies in recent times,” said Abby Glennie, UK small cap manager at Abrdn.

“True it’s been a tough period for the sector – with weaker performance and tightening regulation. But ultimately negative sentiment is just that – sentiment. When you look at the fundamentals, there are many brilliant smaller companies in the UK who are outperforming global and much larger rivals in terms of earnings growth,” she added.

Which regions offer the biggest stock market discounts?

The below table shows whether stock markets look cheap today compared to their longer-term history. The assessment is based on forward-looking price-to-earnings (P/E) ratios. P/E ratios tell you how much you need to pay up front today to get exposure to future earnings. The discount (or premium) figures are arrived at by comparing today’s P/E ratios with the 10-year average.

^{Source: Bloomberg via Abrdn. All data up to 31 January 2025.}

Will UK small cap valuations catch up?

It is all well and good identifying a stock market as undervalued but, for investors to benefit, there needs to be a catalyst for markets to catch up. UK equity enthusiasts have been talking about the sector being undervalued for years. Investors would be sensible to question why now should be any different.

Interest rates are on a downward path, which could spell good news for small cap companies for the reasons introduced previously. There is also a growing sense among investors that the UK could offer a place of stability in an increasingly volatile world.

“Prime Minister Keir Starmer’s meeting with President Trump [last week] went remarkably well, with the President dangling the prospect of a quick trade deal that could see the UK avoid the looming trade war between the US and EU,” said Jason Hollands, managing director at investment platform Bestinvest.

“Investors should remain a little cautious about reading too much into this, as the President’s views can soon chop and change and a trade deal could force the UK to make stark choices about whether it should remain aligned with the EU, but on the surface, this should be seen as encouraging news that might also help restore some optimism in UK equities,” he added.

That said, significant risks remain for those weighing up the case for UK smaller companies. Small caps are more exposed to the domestic economy than large cap stocks, which derive a significant portion of their earnings from overseas. As a result, changes like the increase to employers’ National Insurance contributions from April could affect them more keenly, if the policy creates a stumbling block for UK economic growth, as many have forecast.

A recent survey of 52 leading retailers, conducted by the British Retail Consortium, suggested that 56% of companies are considering reducing employees' hours or overtime in response to the National Insurance policy. Around half are considering a headcount reduction. All of this could translate into less disposable income and therefore less spending in the UK economy.

UK small caps could also take a hit as a result of upcoming changes to inheritance tax rules. Shares traded on the alternative investment market (AIM) are currently exempt from inheritance tax, but this relief will be reduced from 100% to 50% from April 2026. Evangelos Assimakos, investment director at Rathbones Investment Management, said the changes have “put a dent in the optimism of many investors hopeful for a rekindling of this very dynamic market”.

American small caps (firms with market capitalisations of up to $2 billion, although some would include companies worth as much as $10 billon) have traditionally been seen as the best place for investors seeking high long-term returns. They have outperformed large caps since 2000, says Jan Willem Berghuis of Van Lanschot Kempen. Over the past 15 years, however, the small fry have fallen from favour and are “struggling” to match the performance of their larger counterparts, says Freddy Colquhoun of JM Finn. The good news is that economic headwinds are abating and the end of uncertainty over the election is already providing a short-term boost. And as the frenzy around large-cap tech stocks cools, the depth and breadth of the US small-cap market will make it look particularly attractive in the longer term.

Why have US small caps underperformed?

One reason for the recent poor performance by US small caps is that they tend to be more vulnerable to negative shocks to the economy, such as the rise in inflation. The subsequent rise in interest rates particularly hurt a sector that tends to “borrow more and need more regular refinancing”, as Oren Shiran of the Lazard US Small Cap Equity fund points out. Seventy per cent of small-cap debt is coming due for repayment in the next five years, compared with 45% for large-cap debt, says Shiran, and 40% of the debt that small-cap firms hold is on variable rates, compared with only 5% for large caps.

Small caps are also particularly vulnerable to talk of a “hard landing” or a recession in the US, says Alex Knox, co-manager of Premier Miton’s US Smaller Companies and US Opportunities funds. Small caps get around 70%-80% of their revenue from the US, compared with around half for the stocks that make up the S&P 500, “which really isn’t a US index anymore”. So they should be less exposed to ructions in global trade as a result of Donald Trump’s protectionism. In fact, many of the headwinds that have held small caps back are “becoming tailwinds that could push them forwards”, says Knox.

The US Federal Reserve has started to cut interest rates – the base rate is now down by 0.75 percentage points from its peak – and “research suggests that small caps tend to do better during a rate-cutting cycle”. Indeed, the start of a rate-cutting cycle may be one of the reasons small caps have started to “normalise”, performing better than large caps since June. Knox believes fears of a recession are abating and that expectations are shifting towards anticipating a soft economic landing, especially as the US consumer “seems to be in relatively good shape”.

Small caps are Trump trades

Over the past few months, worries about the presidential election, especially over what would happen if Trump lost but refused to accept the result, had been weighing on the sector – “markets don’t like uncertainty”, as Knox says. But with the election now out of the way, and concluded without the disputes and legal battles that many had been dreading, this cloud will now be lifted, leaving small caps space to power ahead. Trump’s victory also removes the risk of US corporate taxes rising from 21% to 28%, something the Democrats had been pushing for, says Dan Squires of Saxo. Such a move would have led to a “swift, one-off negative adjustment” in the prices of US shares, especially those that make their money domestically. As it is, small caps look particularly well placed to benefit from Trump’s proposed programme of tax cuts and deregulation, especially as Republicans managed a “clean sweep” and take the House of Representatives as well as the Senate and White House, says Colquhoun. And it remains to be seen whether Trump will really impose the blanket tariffs he promised on the campaign trail. Colquhoun thinks that fears on this score are overdone.

Indeed, small caps could actually benefit if the US imposes some additional trade barriers in certain sectors, says Mark Ellis of the Nutshell Growth Fund. Tariffs may push up prices for larger firms and for the consumer, and invite retaliation from America’s trading partners, but that would just make goods produced by domestic companies more attractive. After a period in which “large companies have enjoyed the benefits of increasing globalisation”, the “pendulum has already begun to swing in the other direction”, and “many companies in the US have begun to move production back to the shores of the US”, says Matt Mahon of T. Rowe Price. This has created a “unique opportunity” for smaller, US-focused companies to gain from the “resulting job creation, infrastructure development and economic stimulus driven by these long-term capital inflows”, says William Blair Investment Management’s Rob Lanphier.

Were Trump to blunder in his second term, there’s still a limit to how badly things can go, says Chris Metcalfe of IBOSS, part of Kingswood Group – “fiscal and monetary support” is always likely to be forthcoming “at the first sign of trouble, which seems to have become the new playbook for the US, as well as many other countries around the world”.

Why small caps look stunningly attractive

Even if the economic situation ends up being a little bumpier than expected, or Trump’s policies backfire badly, that doesn’t mean US small caps will necessarily suffer. Small caps are valued in such a way that the US economy “doesn’t have to be stunningly amazing for them to do well, just not completely dire”, says Mark Sherlock of Federated Hermes. Indeed, “even though small caps have cumulatively lagged the market since 2011, they have actually grown their earnings faster than the S&P 500”, as Brett Reiner of the Neuberger Berman US Small Cap fund points out. Smaller companies now look “stunningly attractive”, especially when compared with the valuations of larger companies, agrees Sven Anders of JPMorgan.

The forward price/earnings ratio of the Russell 2000 (one of the main small-cap indices) has historically traded at an average forward premium of around 30% to that of the S&P 500, to account for the superior growth potential of smaller companies. Right now, however, the two are trading at similar levels – and, according to other measures, the small-cap index is actually now at a slight discount to the S&P 500.

Another indicator that small caps are good value is that the S&P 500 is heavily concentrated, with just five companies (Apple, Microsoft, Amazon, Google/Alphabet and Nvidia) accounting for around 30% of the market. Just as high levels of market concentration (although on a much smaller scale than today) in the early 1970s and at the height of the tech boom in 2000 were followed by a period where smaller shares did much better, today’s high concentration levels are a bullish sign for small caps, says Anders.

Indeed, one of the reasons small caps have lagged the market is not so much that they have performed particularly badly, but that tech firms have done so well. This trend picked up pace in the last few years thanks to the “halo effect of association with artificial intelligence that has driven up the share prices of the Magnificent Seven”, says Mike Coop of Morningstar Wealth. The strong performance of these tech stocks – Alphabet, Amazon, Apple, Meta Platforms, Microsoft, Nvidia and Tesla – has “shifted investors’ attention from smaller companies”, making their growth prospects seem “less attractive”, says Nefeli Neophytou of Arbuthnot Latham.

But just because we’re living through an “exceptional and unusual time” in some ways doesn’t mean that things will automatically revert to “normal”, says Andrew Holliman of Polar Capital. Still, the “law of large numbers” does suggest that the “exceptional operating performance” of the big names will have to come to an end at some point, “not least due to the growing regulatory risks, as well as the need for ever higher levels of capital spending to maintain their position”. There may be no guarantees that the relative position of small and large caps will change, but “the risk/reward balance favours the former”, says Reiner.

Buy quality small caps

Just because smaller caps in general look attractive, that doesn’t, of course, mean that each individual company is worth buying. “As with any given sector, there are some small-cap firms that are attractive and others that you should avoid,” says Holliman. There are “some great small businesses” out there, but investors should beware buying into what he terms “zombie companies” – those with low profitability and especially high levels of debt, which may look cheap now, but “will struggle to survive in the longer run”.

Investors should focus instead on those companies that are not only profitable at the moment, but will have “room and ability to compound their earnings, so that they will be much bigger in five to 10 years’ time”, says Holliman. Smaller companies tend to be more indebted than larger companies, so making sure that the balance sheet is strong, and that debt levels are manageable, is important for identifying likely survivors. Companies that take on too high a level of debt could end up being wiped out by a sudden shift in the economic cycle, or by an unexpected shock.

Quality companies “have always done well in the medium term”, agrees Sherlock. Investors should think about whether the small-cap companies they are considering buying are generating a consistent amount of cash. Barriers to entry that prevent competitors coming in and pushing down margins or stealing business outright are another thing to look out for. In Sherlock’s experience, the most successful small-cap firms are those that “inhabit a niche area that is big enough to be profitable and enjoy opportunities for growth, but too small for the big companies to be bothered with”.

Choose S&P 600, industrials and biotech

The importance of quality in finding successful small caps is one reason why Sherlock uses the S&P SmallCap 600 (S&P 600) as his preferred small-cap index, rather than the Russell 2000. Both indices cover small companies, but the way that the S&P 600 is selected means that the companies in it tend to be on a much firmer foundation than those in the Russell 2000. Around half the firms in the latter index “aren’t making a profit at the moment”, he notes. These companies may benefit more from falling interest rates in the very short run, but those in the S&P 600 have “better long-term prospects as they are in control of their destinies”.

Dan Boardman-Weston of BRI Wealth Management agrees that the S&P 600 is the more attractive small-cap index. In terms of specific sectors, he likes industrials and thinks that some of the smaller US property companies and real estate investment trusts (Reits) are worth looking at, especially those that deal with industrial property (warehouses, workshops and factories), rather than shopping centres or offices. Small technology companies are another area worth investigating.

But by far Boardman-Weston’s favourite part of the small-cap market is biotechnology. Investors do, of course, have to be “highly selective” when they invest in this area as so much depends on the success of individual drugs and treatments. Boardman Weston notes that biotech valuations have “collapsed” over the past two years, with the sector becoming so unfashionable that “many small biotech companies are now trading below the cash on their balance sheets”. He thinks that this is a mistake as artificial intelligence “will help drug discovery” as well as speed up the development of “treatments that are tailored to the individual patient”.

The US small-cap sector is so large that taken together “it would be one of the top-10 markets in the world with a similar market cap to the FTSE”, says Reiner. Investors who do their homework should “be able to find plenty of good firms that can grow through a market cycle”.

How to invest in US small caps

The easiest way to invest in US small-cap shares is through an exchange-traded fund (ETF) that tracks either one of the two major small-cap indices. The iShares S&P SmallCap 600 Ucits ETF Acc (LSE: ISP6) tracks the S&P 600, which includes companies with a median market capitalisation of $1.74 billion, and has a trailing price/earnings (p/e) ratio of 16.8. The ETF has a total expense ratio of 0.3%. Alternatively, the Invesco Russell 2000 Ucits ETF Acc (LSE: RTYS) tracks the Russell 2000 index, which has a median market cap of just under $1 billion and an average p/e (excluding negative earnings) of 18.31. The total expense ratio is 0.25%.

One active fund to consider is the Premier Miton US Smaller Companies fund. It is a genuine small-cap fund, investing in companies with a market cap of between $100 million and $6 billion at the time of purchase. It also has a strong record, with a total return of 61.10% since its inception in March 2018, compared with 55.5% for the Russell 2000. The basic strategy is to “buy attractive companies and hold them for the medium term”, says Alex Knox, who manages the fund with Hugh Grieves. The fund uses screening tools and research to come up with a list of attractive companies, which it then buys when they become cheap enough. Its largest holdings include Carpenter Technology, OneSpaWorld Holdings and H.B. Fuller. The ongoing charge is 1.03%.

Another actively managed fund that looks attractive is the Neuberger Berman US Small Cap Fund Ucits. Run by experienced managers Robert D’Alelio, Brett Reiner and Gregory Spiegel, it focuses on “high quality, small-cap firms in growing markets with conservative balance sheets that are able to generate significant amounts of free cash flow and a good return on capital”, says Reiner. The team also look for “durable advantages over time, such as intellectual property”. Since its inception in July 2011, it’s beaten the Russell 2000, its benchmark, by around 1.2% a year. The ongoing charge is 0.99%.

Reiner is particularly bullish about Kirby (NYSE: KEX), his fund’s third-largest holding. Although at the larger end of the small-cap spectrum, with a market cap of $7.35 billion, the Houston-based company is the largest inland barge-fleet operator in the US. It has “meaningful scale, very strong operational standards and a reputation for a high level of safety”. It has also been able to acquire other companies in the same area, giving it pricing power, especially at a time when the supply of barges is quite tight. It is a prime example of a small company in a “boring industry” that is consistently able to grow its business through economic cycles. Kirby trades at 18.7 times 2025 earnings.

The JPMorgan US Smaller Companies Investment Trust (LSE: JUSC) also looks interesting. It aims to blend growth and value investing, looking for “good-quality companies with good management teams that benefit from barriers to entry and have good relations with suppliers and customers”, says Sven Anders of JPMorgan. The trust has beaten the benchmark Russell 2000 over the past 10 years, has an ongoing charge of 0.93% and trades at just under a 10% discount to its net asset value. One of its top-10 holdings is MSA Safety (NYSE: MSA), with a market cap of $6.8 billion, which makes safety products, such as helmets and fire equipment. MSA has long-standing contracts with various US government agencies who need to replace their equipment regularly to comply with regulations, “giving MSA a good cash flow”, says Anders. It trades at 21.4 times 2025 earnings.

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At Odyssean Investment Trust we invest in high-quality businesses trading below their fundamental value where management can drive an improvement in underlying performance. We focus on UK smaller companies. We believe that this part of the market commonly fails to appreciate the medium-term potential of a business going through a transformation, instead being more focused on near-term momentum.

This leaves an opportunity for our detailed diligence process to identify investments where management self-help actions can drive operational improvement; we aim to invest before this is priced in by the wider market. As this change is delivered, we hope to then see a double benefit with earnings improving, but also increased interest as more investors buy into the story. Our portfolio today contains a number of these exciting self-help special-situation opportunities.

British small caps undergoing transformations

1. NCC (LSE: NCC) is an example of a business delivering an improvement story. The group is a leading provider of global cybersecurity services, supporting blue chip clients in this secular growth market. Over the past year, the firm has undergone a transformation to improve profitability by restructuring its service delivery operations and accelerating growth by refreshing its approach to engaging with its customers and persuading them to opt for NCC’s services.

This newly improved NCC has started to deliver results, outperforming expectations at its most recent update. With the foundations now in place, we see NCC as set to continue to deliver an improving performance which is underestimated by the market. Despite a strong recent run, the shares still trade below those of cybersecurity peers and below our view of a break-up value for the group.

2. James Fisher and Sons (LSE: FSJ) is at an earlier stage of its transformation. The group is a leading provider of marine services and technical products to the offshore renewable, energy and defence sectors. Over the past 18 months, a new management team has gone through the painful process of disposing of non-core and underperforming assets in order to strengthen the balance sheet.

With this done, management has a clear plan to improve profitability materially through implementing operational best practices and better integration of a diverse group of businesses. We see the path ahead as clear and the team as able to deliver. The rating of shares at an enterprise value-to-sales ratio of below one shows the market has yet to factor in the group’s potential.

3. Genus (LSE: GNS) is another company at the start of its self-help journey. It is a leading provider of genetics to the porcine and bovine industries, with strong market positions and unique intellectual property. The group has suffered from an unusual confluence of downturns in its markets in recent years. These are now stabilising and a new CEO is spearheading an improvement programme focused on bolstering profitability in the underperforming bovine business through concentrating on operational efficiency, commercialising research and development, and value pricing.

Alongside this, the group continues to progress through regulatory approval of novel, disease-resistant pig genetics which, if successful, could materially reshape the group’s profit-and-loss account. Genus’s transformed prospects have yet to be factored into the share price.

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Interest rate cuts aren’t always a cause for celebration if you are an investor. While rate cuts ease pressure on individuals and businesses by lowering borrowing costs, they can also signal that the health of the economy is declining.

For the past three years, investors and economists have been speculating about the likelihood of a “soft landing”. Would central banks be able to raise rates just enough to tackle inflation, before lowering them in time to prevent a recession?

For a while, the picture looked positive. Economies proved surprisingly resilient in the face of higher rates and stock market performance looked good. After a rough year in 2022, the S&P 500 delivered back-to-back returns of more than 20% in 2023 and 2024. Global equities weren’t too far behind.

Despite this, the picture has become more complex in recent weeks. US president Donald Trump has spooked businesses, households and investors with his erratic tariff regime which threatens to push inflation higher and dampen economic growth.

While interest rates remain an important consideration for investors as they construct their portfolios, it is impossible to take advantage of the shifting interest rate environment without first considering the latest geopolitical developments.

Firstly, geopolitical developments will influence the speed and extent of rate cuts. Secondly, they will influence what's behind them. In other words, are central bankers cutting rates because inflation has come under control or because growth has become a concern?

These considerations will shape whether investors are bullish or defensive in their approach.

1. Gold

The current interest rate environment could make gold attractive. The gold price tends to rise when interest rates are cut, as gold (which pays no interest) becomes more attractive on a relative basis as the yield on cash falls. The gold price has continued to hit new highs so far this year and is up around 11% year-to-date.

Beyond interest rate considerations, gold bugs will tell you that the yellow metal is always a good thing to have in your portfolio. It holds its value well, meaning it can act as a hedge against inflation. It also has a low correlation with equity markets, which means it offers good diversification potential.

Demand for the asset remains strong, and safe-haven buying could propel it even higher going forward. Physically-backed gold ETFs saw significant inflows in February totalling $9.4 billion, the strongest since March 2022, according to the World Gold Council.

“Recently, Trump's tariffs have increased uncertainty and market volatility, which supports the likelihood of gold being viewed as a safe-haven asset. These factors have traditionally driven investors toward gold as a reliable investment during unstable times,” said Rick Kanda, managing director of The Gold Bullion Company.

See MoneyWeek’s round-up of the best gold ETFs.

2. Bonds

Bond prices tend to rise when interest rates fall, as the coupons on existing bonds start to look more attractive than those on new issues. With further interest rate cuts expected over the course of 2025, the asset class could be worth a look. Yields are still high, meaning a decent level of income is on offer too.

When weighing up which sorts of bonds (or bond funds) to include in your portfolio, there are a range of considerations – from credit quality to duration. As recessionary risks ramp up, investors might want to opt for more creditworthy parts of the market. This could include developed market government bonds or high-quality investment-grade corporate bonds, where the risk of defaults is minimal.

Another reason for opting for more creditworthy bonds in today’s environment is that credit spreads (the premium investors get paid for taking on more credit risk) are currently quite tight. In other words, investors are not being compensated that well for buying riskier bonds.

When it comes to duration, some might make the case for investing in bonds with longer maturities to “lock in” higher interest rates for longer. However, with inflationary pressures heating up again, this approach could come with risks.

“Although longer-dated bonds have high yields which can be locked in, the market volatility of these bonds can result in significant swings in value,” said George Martin, senior fixed income analyst at wealth management firm Charles Stanley. For this reason, he favours shorter duration bonds around the two-to-three-year level.

The longer a bond’s duration, the more sensitive it is to changes in inflation expectations. “Longer-dated bonds therefore carry a higher level of risk, and in a world where inflation doesn’t get back to the central bank's 2% target, investors could see losses, despite the bonds having a high yield on paper,” Martin added.

3. UK dividend stocks

Although bond prices will rise as interest rates fall, the level of income on offer in the bond market will start to come down. The same is true for cash yields. We have already seen a barrage of interest rate cuts in the savings market over the past year. As this takes place, investors who are reliant on income may need to consider increasing their allocation to dividend-paying equities.

The UK market is a fertile ground for dividend stocks. Currently, the FTSE 100 is offering a 12-month forward dividend yield of 3.8%, based on Factset data. The FTSE 350 is slightly higher at 3.9%. This is not too far behind 10-year government bonds, which are yielding 4.7% at the time of writing. Share buyback activity has also risen in the domestic market in recent years, meaning the real cash return investors are getting is higher than the dividend yield would suggest.

“Thus far in 2025, the UK equity market has offered more dividend increases than it has cuts, more share buyback announcements in value terms than at the same stage in 2024, and more positive surprises than negative ones,” said Russ Mould, investment director at platform AJ Bell. “This is all despite what appears to be, on the surface, a gloomy macroeconomic backdrop and a tense geopolitical one.”

If the domestic market continues the year as it started, with strong share price performance, you could also benefit from capital growth. Stock markets around the world have taken a hit in recent days, but the FTSE 100 is still up around 3% year to date. This compares favourably to the S&P 500, which is down almost 5% over the same period.

Alternatively, if the market takes a downturn, dividend stocks could prove a defensive play. The ability to regularly pay a consistent (or rising) dividend to shareholders is often a sign that a company has good financial discipline.

4. If you are more bullish on the growth outlook… small caps

Those who are more optimistic about the economic outlook might want to focus on less defensive areas of the market. For example, if you think recessionary fears are overblown, small cap stocks could be worth a look.

Smaller businesses typically suffer during periods of high inflation and interest rates. It can be more difficult for them to swallow price increases and they are often more leveraged (and more exposed to floating-rate debt) than their larger counterparts. As inflation comes under control and interest rates fall, they can rally.

Research from global investment company Aberdeen, published earlier this month, suggests UK small caps offer particular opportunities, trading at a discount of more than 24% compared to their 10-year average.

That said, it is worth pointing out that they could take a hit from the increased labour costs coming in from April. “Smaller firms may find it harder to adjust to the increased costs brought by the [higher] minimum wage and higher national insurance contributions,” Mould notes.

Since 1955, the Numis Smaller Companies index, representing the bottom 10% of the UK market, has returned a compound 14.1% per annum compared with just 11% for the FTSE All-Share index. But its outperformance has been far from consistent. 

Small caps underperformed for most of the decade to 1998 before bouncing back strongly in 1999. They have underperformed again since 2016, and now trade at less than 12 times expected earnings, below the long-term average. This is more expensive than the FTSE 100, which trades at a 15%-20% discount to its long-term average. 

But, it is argued, there is much more growth potential in smaller companies than in large ones. Small-cap managers such as Robin West of Invesco Perpetual argue that small caps’ performance will bounce back, as it did in 1999. 

“Average returns when small caps were this cheap have been 22% over the next 12 months and 42% over the next 24 months,” he says. With the shares of small-cap trusts, such as his, trading on discounts to net asset value (NAV) of 10%- 15%, this precedent promises excellent returns. 

Two small cap trusts under the spotlight

It depends, however, on growth in corporate earnings, which hasn’t been helped by the increase in the rate of corporation tax from 19% to 25%. A small-cap manager needs to find companies with exceptional prospects to overcome political and fiscal headwinds, to take an active role in shaping the company’s management and strategy, and to guide the company towards a sale at a premium. 

That is what two trusts under Harwood Capital Management’s banner, Rockwood Strategic (LSE: RKW) and the Odyssean Investment Trust (LSE: OIT), seek to do. Rockwood is managed by Richard Staveley and has a market value of £90m; Odyssean is managed by Stuart Widdowson and Ed Wielechowski, and has a market value of £230m. Both have concentrated portfolios. 

Odyssean has fewer than 20 holdings, while Rockwood aims for between 25 and 30. Rockwood typically invests in companies with a market value of below £200m while Odyssean’s companies are larger. It focuses on higher quality growth companies, while Rockwood is keener on “recovery” plays (struggling companies with the potential for a turnaround).

Index-beating five-year returns

Both trusts trade at a premium to NAV, which has enabled them to issue new shares. Although Odyssean returned an underwhelming 9% over the last year against 14% for the Numis index, its five-year return of 66% is far ahead of the 26% for the Numis index. Rockwood’s numbers are even better: 23% over one year and 129% over five.

Odyssean’s fortunes appear to be picking up, with a second-quarter return of 10.4%, twice that of the Numis index. Two of its largest holdings, Elementis (13% of the portfolio) and XP Power were bid for by private equity this year. Both bids were rejected as undervaluing the companies, despite XP’s bid representing a 70% premium to the prevailing share price. 

Widdowson and Wielechowski are optimistic about their other large holdings, cybersecurity consultant NCC (14%), inkjet manufacturer Xaar (9%) and industrial LED specialist Dialight (6%). Proceeds from the takeover of Ascential, previously a 10% holding, were received in May and “we are not short of good investment ideas”, say its managers.

Takeover benefits

At Rockwood, Staveley has also benefited from a series of takeovers and he expects more as the small-cap sector continues to shrink. Like Odyssean’s managers, his approach is “to engage with companies rather than be hostile. 

The key is to come up with a good idea”, although that often involves installing a new chairman or CEO. Rockwood’s holding in a company may be modest, but if other Harwood funds also own shares, management will listen. Rockwood’s largest holding, at 11.6% of the portfolio, is RM, a supplier to the UK education market. The company “has agreed to dispose of two divisions, enabling it to pay off £50m of debt”. That will leave it with market-leading positions in “assessment services”, marking exams internationally, and in educational supplies to primary schools in the UK. In exam marking, it has recently been awarded a new contract with International Baccalaureate “worth £100m”, underpinning growth of 10% per annum and 22% margins. RM is currently valued at £70m, but Staveley thinks it is worth £175m.

Filtronic, 10% of the portfolio, was once a telecoms technology high-flyer but made a disastrous acquisition and its market value fell to £25m, when Staveley started buying. It is still a market leader in walkie-talkies technology, but the excitement comes from its emerging interest in space, where it has gained key contracts with SpaceX’s Starlink phones network and expects to win business from Jeff Bezos’s space venture. 

SpaceX has acquired warrants in Filtronic and its market value has multiplied to £160m. Other holdings include Capita, “the biggest blind spot in the UK market: everyone who has tried to own it has lost money”. The market value fell to £240m compared with £2.6bn of sales, but Staveley thinks the target of margins of 6%-8% is “unambitious”. 

The pension problem has been solved, the debt is mostly repaid following the sale of a software business and the stock is recovering. Staveley has also bought 3% of lending platform Funding Circle, which listed at a value of £1.5bn in 2018, but has never made money. Its share price fell by over 90% despite “£175m of unrestricted cash”. Costs have been cut, a loss-making US business sold and “Investec thinks profits could reach £35m in two years”. The share price has trebled since Staveley started buying.

The end of the index is just the beginning

Investment bank Peel Hunt has pointed out that the number of companies in the FTSE Small Cap index (which excludes Aim) has fallen from 160 in 2018 to 114 at the end of 2023. “If this decline continues, the index will cease to exist in 2028,” it says. This has caused much anguish among small-cap managers, but it may prove too alarmist. 

Whether the UK’s small cap sector disappears or recovers, the managers of these two trusts at Harwood see plenty of opportunity for profit, whether from companies prospering or being taken over. The former will often lead to the latter and Harwood, unlike most managers, takes an active role in guiding them in the right strategic direction, using considerable in-house private equity experience. 

The toughest call is to decide which one to buy. Perhaps both?

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Data stretching back to the 1950s reveals a “smaller-companies effect”: small stocks outperform larger ones around the world. They are less liquid, riskier and less well-known than their bigger counterparts – outperformance compensates for these shortcomings. 

In recent years, though, smaller companies have been left behind. In the UK, for example:

• The Numis index, comprising the bottom 10% of the market, has returned 11% over the last three years and 5% over five. 
• The All-Share index has returned a respective 34% and 23%. 
• The MSCI World Small Companies index has returned 15% in sterling over three years and 28% over five.
• The All Countries World index has returned 24% and 52%. 

This trend of underperformance discourages people from investing in smaller companies, creating a vicious circle. At some point, this cycle will reverse suddenly and dramatically, but the timing is impossible to predict.

If times are bad for smaller companies in general, they are worse for small-cap funds, especially investment trusts. Most of them have underperformed their benchmark indices and the discounts to net asset value (NAV) at which their shares trade have widened dramatically. The average global fund has lost 5% over three years, 20% behind the index, in NAV terms, but the average share-price decline has been 13%, according to Winterflood Securities. In the UK, the average fund has returned 12%, 23% behind the index in NAV terms and 15% in share-price terms, as discounts to NAV have narrowed a little.

Not all small-cap funds are lagging their benchmark index. The winners are overwhelmingly those that focus on investing in “value” rather than “growth” companies. This is in marked contrast to larger companies, where “growth” has outperformed thanks to the startling performance of the top eight US mega-caps in the S&P 500 index. Also notable is that the outperforming small-cap funds are mainly “active value” trusts in which the manager doesn’t just wait for the management of an undervalued and underperforming company to instigate a recovery strategy, but prods them into action.

What makes this possible is that the stake owned by a trust’s manager and associates will be larger than in a big company, so management is much more likely to respond if shareholders agitate for a general meeting to oust the directors. In the UK and much of the world, the recovery strategy of a large or medium-sized company is left to management, which means it can be a long wait for shareholders. Here are the most conspicuous outperforming small-cap trusts:

1. North Atlantic Smaller Companies

The £675m North Atlantic Smaller Companies (LSE: NAS) trust, managed by Christopher Mills since 1982, has risen 200-fold, including dividends, in the last 40 years. Mills is very much an active-value investor, combining a persuasive and nearly always successful combination of carrot and stick. He has sat on the board of over 100 companies in his career, founding Harwood Capital, which has £2bn under management, in 2013.

The portfolio is invested in sister trusts, such as Oryx and Odyssean, private-equity funds and companies such as Polar Capital and Ten Entertainment. UK exposure is significantly higher than in the past. Performance over the last year has been just 3%, despite a flurry of takeovers in the portfolio, but the three- and five-year numbers are well ahead of the benchmark at 23% and 41%. Despite this, the shares trade at a 31% discount to NAV. With a personal stake of over 28% of the company, nobody can doubt Mills’s commitment.

2. Aberforth Smaller Companies

With over £1bn of assets, Aberforth invests solely in the UK market as a passive value investor. The Aberforth Smaller Companies (LSE: ASL) trust has returned 39% over three years. Although the 7% over five years, reflecting more difficult times for value investing in 2019 and 2020, is mediocre, the annualised return since launch in 1990 of 11.6% is more than 2% ahead of the Numis index. Despite this, the trust trades at a 12% discount to NAV and yields a relatively generous 3.5%.

The trust is broadly spread with no holding over 3% of the total. Borrowings at just 3.7% of net assets are low and annual expenses comprise just 0.8% of net assets; 39% of the portfolio is in the FTSE 250 midcap index, against 70% for the Numis index. In May, the managers pointed out that the valuation of their portfolio was “unusually low” at just 7.5 times historic earnings, close to the lowest since inception, despite “resilient earnings. The stockmarket is more than pricing in a recession”. The shares remain great value.

3. Odyssean Investment

Odyssean Investment (LSE: OIT) is a £166m trust in the Harwood stable, launched a little over five years ago and managed by Stuart Widdowson and Ed Wielechowski. The underlying performance over three years has been 29%, but the shares have returned 41% thanks to the discount of the shares to NAV disappearing. Over the last year, performance has been disappointing.

“Though a few things have not been going quite the right way,” says Wielechowski, “we are very, very confident about the medium to long term as we see a lot of potential value in the portfolio.” 

The portfolio consists of no more than 25 holdings (the top ten currently account for 83% of the total), bought with a three- to five-year investment horizon. The market value of these companies lies between £100m and £1bn and an international focus means that under 25% of their sales stems from the UK. The trust seeks “constructive corporate engagement” through large “influencing but supportive” stakes.

4. Rockwood Strategic

Rockwood (LSE: RKW) has been in the Harwood stable for barely a year but is already shooting the lights out, returning 21%. The £47m trust is managed by Richard Staveley, who brought the trust over from Gresham House against its will. The investment style is very similar to Odyssean’s, but the companies are smaller. The top seven holdings account for nearly half the portfolio and all have a market value below £100m.

The shares trade at NAV which has enabled modest share issuance. Significant further issuance is likely and merited.

5. Strategic Equity Capital

Strategic Equity Capital (LSE: SEC), once managed by Stuart Widdowson, is now managed by Ken Wotton at Gresham House. 

Performance of the £150m trust continues to be strong – 43% over three years and 19% over one – but the shares have slipped to a 9% discount to NAV. The style, unsurprisingly, is similar to Odyssean’s, applying “a private-equity approach to public markets”. The top ten holdings account for 74% of the portfolio with the largest, XPS Pensions, 17%. 

6. European Smaller Companies

Although European Smaller Companies (LSE: ESCT) has only returned 16% in the last three years, the comparative index has returned just 6% and ESCT’s three competitors are down by double digits. Despite this, its shares trade at a 13% discount to NAV, in line with its competitors. 

Ollie Beckett, the manager, describes the trust as investing in “the winners of tomorrow in areas where you tend to find growth”, but “we are more valuation-focused than some of our peers. Valuation does matter, but ultimately we are seeking undervalued growth companies”. In addition, “unlike others, we will also invest in recovery names”. 

The £725m portfolio has over 120 companies, none over 3% of the total, with an average market capitalisation of £1bn. Industrials make up a hefty 39% and management is passive. The shares yield 3.4%, dividends having been increased at an impressive compound annual rate of 17% in the last nine years.

7. Nippon Active Value Fund

Nippon Active Value Fund's (LSE: NAVF) 56% return over the last three years, helped by a 26% fall in the yen relative to sterling, has enabled the trust to absorb two less successful trusts, Abrdn Japan and Atlantis Japan. This has turned it into a £290m trust trading at an 8% discount and yielding over 2%. 

The trust follows an “activist approach”, but the activist approach in Japan needs to be a lot more discreet and polite than in the UK or the US. “You have to find companies willing to change,” says co-manager Gifford Combs. This requires local expertise and extensive knowledge: the team has been investing in Japan for over three decades. 

The portfolio focuses on manufacturing companies, which have benefited from the yen’s weakness. “We can buy companies trading at less than book value [and] three and nine times current earnings.” So there is plenty of upside in the portfolio. 

8. Asia Pacific ex-Japan trusts

All three small-cap trusts in the Asia Pacific region have performed well, returning between 35% and 50% over three years, as have the two small-cap-focused India trusts, both almost doubling. 

These are all passive rather than active value funds and, although value-aware, have no particular style bias to growth rather than value. Their markets have been favourable to smaller companies, resulting in good performances, but the discounts to NAV have still widened to 10% (in the case of Fidelity Asian Values, LSE: FAS) and 15% (Abrdn Asia Focus, LSE: AAS and Scottish Oriental Smaller Companies, LSE: SST). This makes them attractive.

A recovery in the performance of smaller companies in developed markets is likely to be led by a return to favour of the “growth” style and accompanied by narrowing discounts and trusts outperforming their benchmark indices. The “value” trusts, now on relatively low discounts, may well be left behind. The passive funds, like Aberforth, have a long record of swinging from the top of the performance table to the bottom and back again, while active value funds may find fewer opportunities as share prices rise.

This should not put investors off but rather encourage them to invest in both growth and value trusts for the long term. The small-cap effect was first highlighted by studies in the late 1980s, but it has, for now, been discredited. In five years’ time, it may become accepted wisdom again.

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• Funds to buy UK small cap stocks on a discount

May was a positive month for the stock market, and DIY investors took advantage to increase their exposure to growth stocks and funds.

Despite the ‘Sell in May’ adage, major indices rose during the month. The S&P 500 soared 5.1%, while the FTSE 100 made modest gains of 0.3%.

Data from investment platform Interactive Investor (ii) shows DIY investors on its platform piled into artificial intelligence (AI) stocks and funds in particular. Semiconductor company Micron Technology (NASDAQ:MU) was the most-bought stock among ii’s DIY investors during May.

“A combination of surging AI demand, supply shortages and price hikes have pushed [Micron’s] stock to fresh highs and ignited heavy buying among ii customers,” the company’s head of investment, Victoria Scholar said.

Meanwhile, the most-bought active funds and exchange-traded funds (ETFs) reflected a divide between investors minded towards protecting their wealth and those seeking growth.

Which other stocks and funds were the most popular among DIY investors last month?

The most-bought stocks in May

Besides tech megacaps like Micron and Nvidia (NASDAQ:NVDA), the rest of ii’s most-bought stocks during May reflect investor appetite for staple UK companies.

“FTSE 100 heavyweights like BP (LON:BP.), Legal & General (LON:LGEN), Lloyds Banking Group (LON:LLOY) and Glencore (LON:GLEN) were popular choices among ii customers last month,” said Scholar. “NatWest (LON:NWG) was a new addition while FTSE 250 low-cost carrier easyJet (LON:EZJ) dropped off the list.”

^{Source: Interactive Investor}

The most-bought funds and ETFs in May

Money market funds have been popular picks for defensively-minded investors throughout much of this year, and that remained the case in May with the Royal London Short Term Money Market Fund topping the list of the most popular open-ended funds.

But alongside this, more adventurous strategies such as technology funds were popular among DIY investors, with new entrant VanEck Semiconductor UCITS ETF (LON:SMGB) proving the fourth-most popular passive fund.

“Many semiconductor shares have posted impressive returns so far this year, increasing the demand for funds in this sector,” said Tom Bigley, fund analyst at Interactive Investor.

Bigly noted that Micron, the top holding in VanEck semiconductor, has risen more than 200% so far this year as demand for high-bandwidth memory for AI servers has exceeded supply.

^{Source: Interactive Investor}

Technology was a prominent theme among actively-managed funds too, with two forms of the Polar Capital Global Technology fund appearing in the top 10 list as well as WS Blue Whale Growth Fund.

The most-bought investment trusts in May

Tech and innovation-focused investment trusts were also popular with DIY investors during May. Innovation-focused Scottish Mortgage (LON:SMT) retained top spot from the previous month: the trust’s largest holding, SpaceX, is expected to IPO in June, and as such was the focus of much investor hype during the month.

Investing in the space theme was clearly flavour of the month, as Seraphim Space (LON:SSIT) was the third-most popular investment trust on Interactive Investor, just behind the Polar Capital Technology investment trust (LON:PCT).

^{Source: Interactive Investor}

The Russell 2000 is known as the world’s “biggest small index”. It offers investors the chance to invest in the heart of America. These small- and mid-cap stocks are diverse and offer more domestic focus than the multinational giants at the top of the S&P 500. In addition to providing important portfolio diversification, smaller companies typically outperform in the long run, owing to their greater scope for long-term growth.

Excluding the “Magnificent Seven” from the S&P 500’s return in 2023, it reveals that the remaining 493 stocks actually lagged the Russell 2000. Small caps have recently traded on historically wider discounts to large caps. However, 37% of the Russell 2000 index is unprofitable, and small caps have an average leverage ratio of 4.3 times. Disparities between market averages and individual stocks require active management to identify the winners and losers. Our investment process focuses on three key attributes: quality businesses, quality management and attractive valuations. Here are three firms that meet these criteria.

US small cap safe bets

MSA Safety (NYSE: MSA) is the global leader in the development, manufacturing and supply of safety products that protect people and facilities. MSA’s core products include self-contained breathing apparatus and other protective gear for firefighters; gas and flame detection systems used in a variety of industrial settings; and industrial head protection and fall-prevention equipment. Given the mission-critical and non-discretionary nature of safety products, MSA tends to experience less cyclicality than other industrial companies, with regular replacement of safety equipment often mandated by law. The company makes a healthy profit and requires limited capital investment, driving strong and durable cash flows.

Encompass Health (NYSE: EHC) is the largest operator of patient rehabilitation facilities in the US. As rehabilitation services are needs-based, patient volumes tend to be non-cyclical, while also benefiting from demographic trends as the US population ages. The combination of steady revenue growth, attractive profit margins and strong cash flows is a testament to the quality of the business, and we think Encompass’s strong management team and attractive valuation make the stock a promising investment.

MACOM Technology Solutions (Nasdaq: MTSI) designs and manufactures semiconductor technologies for optical, wireless and satellite networks. Macom has diversified exposure to applications in the industrial, telecommunications and data-centre markets, with the company’s multi-decade record and more than 600 patents underpinning a strong competitive position.

US small caps powered by artificial intelligence

Macom generates very attractive profit margins and strong cash flows, and is run by a management team with a history of creating value for shareholders. Recently, shares have benefited from the group’s exposure to optical components for artificial intelligence (AI) applications with data centres, which has driven a strong rally in shares. While we’ve taken some profits on recent strength, Macom remains a high-conviction position for the long term.

The US economy remains strong, with falling inflation and rising real wages offsetting dwindling savings and tighter credit conditions. We think moderate consumption growth should carry the US economy to a soft landing. We remain positive about small caps thanks to compelling valuations and strong fundamentals. Robust earnings growth, combined with low valuations, could drive small caps to regain the momentum of 2000-2011, when they outperformed. Investors remain underexposed to small caps. However, as their fundamental merits are rediscovered, we anticipate a return to the sector.

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The TM CRUX UK Special Situations Fund contains mostly mid- and small-caps and targets capital growth over the long term. We have traditionally done best when the stockmarket recovers and we like to buy long-term growth companies when times are difficult.

This has proved very profitable for us over 17 years: over this period we have returned 10.4% versus 6.2% for the IMA UK All Companies sector. Performance has been highly biased towards recovery periods and we delivered 168% and 150% returns in the recoveries of 2009 and 2020.

The UK trades at a 30% discount to global equities. We think large companies such as Shell, Glencore and Legal & General have great appeal, but even better returns will come from the small and mid-caps below that have been oversold. The current mood is one of extreme pessimism and, with low valuations in the British market, we believe now is a very attractive time to invest.

Cheaper than the sum of three parts

Ascential (LSE: ASCL), at 242p, is a cheap but slightly complicated medium-sized special situation. The business consists of three different divisions and the sum of the parts has for some time appeared to be significantly higher than the share price.

Recent results have reflected the company’s resilience, with the events business benefiting from the post-Covid recovery, offsetting any weakness elsewhere. Most significantly, the company has declared its intent to break itself up to realise value.

The events business will remain listed in the UK. The high-quality, highly prized business information business WGSN will be sold, and the digital content business will be listed on the US Nasdaq market.

Recent brokers’ notes suggest a sum-of-the-parts valuation between 380p and 450p using conservative assumptions; the current price is 248p. It is somewhat surprising that the shares have not responded more strongly to the clear strategy to break the business up.

IP Group (LSE: IPO) is a UK mid-cap that is discounting too much bad news. The company helps fund innovative technologies from the UK’s leading universities. Venture funding is an area under pressure owing to rising interest rates. The group’s recent estimated net asset value of 130p per share will come under some pressure. However, we note that some of the investments, such as Featurespace, a software group using artificial intelligence (AI) to combat financial crime, are highly promising and should raise money successfully. Today’s share price of 60p is unrealistically pessimistic and we believe that IP Group will soon repeat its 2020 recovery, when the shares rallied from 50p to 150p.

A proven software strategy

AdvancedADVT (LSE: ADVT) raised money at 100p to allow seasoned software investor Vin Murria to acquire software businesses and improve them. Murria has had three successful iterations of this strategy at Kewill Systems, Computer Software Group and Advanced Computer Software Group. She raised money and invested £16m herself at 100p per share.

Today the shares languish at 71p and the firm has around 95p per share in cash and shares. Paradoxically, the more difficult the economy, the better the odds of finding the bargain needed to kick off “the investment story”. The shares could bounce by 50% or more on a deal, and would return 95p-plus in the unlikely event that no deal is found. It’s a small company, but one widows and orphans could readily invest in.

The new tax year is fast approaching and with it a series of changes to tax and allowances.

According to research from investment manager Wealth Club, these upcoming changes are pushing investors to consider more tax-efficient investments, such as Venture Capital Trusts (VCTs).

While these investments are certainly not suitable for all investors, their tax benefits, and exposure to smaller, faster-growing businesses, make them an attractive proposition for experienced investors.

Here are some of the benefits of buying VCTs and the risks you need to look out for as well.

Boom time for the VCT industry

VCTs have been increasing in popularity for some time now as fiscal drag eats away at high-earners’ after-tax income.

Data from HMRC shows investors put £1.1bn into VCTs during the 2021-2022 tax year, a 68% increase from the year before and up 240% from the £325m raised ten years ago in the 2011-2012 tax year.

These investment vehicles invest in small, early-stage, often privately-owned companies, which tend to be riskier investments. So, to offset some of the risks, and encourage investors to fund the sector, the government offers generous tax relief on VCT investments.

You can invest up to £200,000 in VCTs per tax year and receive tax relief of up to £60,000.

Note that you must hold the investment for at least five years to keep the tax relief.

Additionally, VCTs dividends are also tax-free.

The table below, supplied by Wealth Club, shows what taxable dividend you would currently need to match different rates of tax-free yield:

However, while these tax breaks might look attractive, it’s never sensible to invest in something for tax reasons alone.

Indeed, any investment comes with risk, but VCTs are particularly risky. You could lose all of your investment, wiping out any tax savings in the process.

But VCT investing is not just about tax relief, says Alex Davies, founder of Wealth Club. “Investors are increasingly realising that growth and innovation are not likely to come from the large corporates you find on the main stock market, but rather from young, ambitious, and entrepreneurial start-ups,” says Davies.

“Not all will succeed but there’s now much more support compared to, say, 10 years ago – from incubators and accelerators to public and private funding – so they should have a better chance.”

With all of this in mind, here are three VCTs to look into before the end of the tax year.

Baronsmead VCTs

Baronsmead Venture Trust and Baronsmead Second Venture Trust are “two of the largest and most diverse of all VCTs”, says Davies.

They offer investors exposure to a portfolio of over 85 companies, including AIM-listed and private companies, early-stage growth investments and old-style management buyouts.

The trust is managed by Gresham House, which invests mainly in technology companies.

“The VCTs target an annual dividend yield of 7% of NAV – one of the most generous policies in the market – and have achieved this in each of the last five financial years,” says Davies.

British Smaller Companies VCTs

British Smaller Companies VCT (BSC) and British Smaller Companies VCT2 (BSC2) offer investors access to 35 companies, mainly providing business services. The largest holding is the business intelligence analytics platform Matillion.

“The VCTs don’t state a dividend target, but over the five years to 31 December 2022 paid total dividends per share of 38.5p (BSC) and 27.8p (BSC2).”

Octopus Titan VCT

Octopus Titan VCT invests in over 115 companies and has net assets of £1.1n. It’s the largest VCT in the UK, and one of Europe’s largest as well.

The VCT has a “long track record of investing in some of the UK’s fastest-growing technology companies, from Zoopla, the first $1 billion VCT-backed company, to fashion marketplace Depop and leading pet insurer Many Pets”, says Davies.

It’s targeting an annual dividend of 5p per share, and in the ten years to December 2022 has paid total dividends of 91p per share.

Michael Taylor of Shifting Shares reviews his 2023 portfolio and picks his favourite small caps to buy for 2024.

Investors who are not comfortable in picking their own shares might want to look to funds instead. And there are lots of other tempting options in our guide to the top stocks for 2024.

2023 portfolio review
Small-cap stocks have struggled this year. None of the four stocks I chose at this stage last year finished in the black, despite some big gains during 2023.

1. Brave Bison (Aim: BBSN), a media, marketing and technology play skewed towards social media, is currently down by 10%. This surprises me. It was cheap when I included it, and the brother directors (Oliver and Theo Green), who managed to expand their previous firm, Tangent, bought five million shares in November. I see no reason to abandon this position.

2. Altitude (Aim: ALT), a promotional products company that owns a platform connecting buyers, distributors and manufacturers, is unchanged. Investors may be loath to buy because the stock isn’t cheap, but profits are growing quickly. Once earnings catch up and bring the valuation down, the stock could bounce. If anything, the business case has become even stronger.

3. Australia’s Harvest Minerals, which produces the fertiliser KP Fertil in Brazil, has been a dreadful performer, slumping from 8.4p to 0.71p as fertiliser prices have slumped. If the business case recovers then the stock is a multi-bagger – but investors face the very real risk of a discounted placing or even a delisting. I would now avoid the stock until much of the uncertainty is removed. I’m happy to admit I got this one wrong.

4. Finally, XP Factory’s shares have slipped from 21.5p to 16p, but the company appears to be trading strongly. Escape rooms and experiential leisure are proving popular, and the Boom Battle Bar has been a solid acquisition. It offers a range of games including axe throwing, and is popular with parties. All the right metrics are pointing north. Cash is not a concern and the group should be able to keep funding its expansion.

Top small caps to buy for 2024

This year’s selection comprises a mix of profitable small caps and two high-risk special situations that are unprofitable yet have plenty of upside.

As always, consider them as suggestions for you to do your own research. I have done my best.

1. Renold (Aim: RNO), 34p

Renold is a manufacturer of industrial, bicycle and motorcycle chains, and machine components. It’s a thoroughly unexciting business, and yet the stock price has more than held its own in the past two years as the company has repeatedly put out good news. 

After the last update, house broker Cavendish produced an adjusted earnings-per-share (EPS) target of 6p for 2024, with £19.2m of adjusted profit forecast. At the current price of 34p, that means the stock is trading on a price/earnings (p/e) ratio of less than six. There has been no dilution of shareholders since 2018. 

The business is self-funding small, bolt-on acquisitions and so there doesn’t appear to be a need to come to the market for more cash. There is, however, a large pension deficit sucking capital from the business. Net cash flow (after tax) was £11.7m in the six months to 30 September, but there was a £6m outflow for pension contributions. Still, £2.6m of this was accelerated and originally planned for the second half of Renold’s financial year. The deficit will become smaller over time, so I don’t believe this is anything to worry about. 

I am quietly confident that in the coming bull market, Renold could double from this level. That won’t happen overnight unless someone bids for the entire company. But it is a resilient business on the front foot. Given the earnings growth, the market may eventually want to rerate the stock from six times earnings to a higher value.

2. Supreme (Aim: SUP), 112.5p

Supreme is Europe’s leading provider of wholesale batteries, lighting, vaping and nutritional products. 

It has established close ties with Duracell and Panasonic, but it’s the vaping side of the business that attracts attention. Many say this is because it is a nicotine product and thus triggers a similar reaction to alcohol, tobacco and gambling companies. But while all of these can be addictive and ruinous, I am confused as to why defence companies are often left out of discussions about ethical investments. People can choose to smoke, drink, gamble, and vape. Nobody chooses to be bombed. In any case, everyone is entitled to their own opinion. 

It has been suggested that this company may not achieve the valuation it would otherwise deserve because of objections to vaping. I don’t believe that, as the numbers are compelling. This is a fantastically profitable business, and house broker Shore Capital expects EPS of 17p this year, giving the company a price/earnings (p/e) ratio of seven at the current price of 120p. 

On the cash front, there was an outflow of £2.7m overall in the half-year to 30 September, but this was due to a £16.4m investment of working capital to support ElfBar– Supreme had been selected as a master distributor for the online vape store brands ElfBar and Lost Mary. Excluding this investment, operating cash flow was £17m. The company has £5m of net debt but also an unused £35m debt facility to make more acquisitions. 

This sounds good so far, but there may be trouble ahead. We are awaiting the results of the consultation on possible new UK e-cigarette regulations that ended on 6 December. The company has made moves to pre-empt this by changing packaging to make it less appealing to children, but will it be enough? Under a Labour government, vapes may only be available under prescription, following Australia’s move in 2021. My feeling is that removing a less harmful way of getting a nicotine hit and a way for smokers to reduce their cigarette consumption – some people use vapes to help them give up smoking altogether – makes no sense. But it’s clearly a big risk. 

Supreme has also seen plenty of growth, although this has largely come from ElfBar, which it doesn’t actually own. I believe the balance between potential risk and reward is priced attractively on a p/e of seven.

3. Afentra (Aim: AET) 31.5p

Oil and gas explorer Afentra, short for “African energy transition”, changed its board in May 2021. Paul McDade, former CEO of Tullow Oil, now runs the firm. He plans to buy assets and use his knowledge and connections to improve them. 

The company finally completed its Sonangol acquisition in Angola on 8 December. This is a deal that gives the company non-operating interests in two areas in offshore Angola. The deal is scheduled for completion on 1 December next year. Afentra should be able to generate $49m in adjusted EBITDA in 2024, compared with a current market value of £70m. Profit before tax is forecast to reach £23.8m, meaning the company will trade on a single-digit p/e, assuming everything goes to plan. The Sonangol acquisition will provide free cash flow for the company to buy existing assets as well as provide lending facilities with which to go after more targets. 

A bet on Afentra is a bet on CEO Paul McDade. He has certainly bet on himself, scooping up £199,550 of shares in August 2022.

4. BSF Enterprise (LSE: BSFA)

BSF Enterprise is a biotechnology company that acquired cell-based tissue engineering company 3D Bio-Tissues in 2022. A share placing allowed it to raise £1.75m at 7.37p to finance the takeover, and it mustered another £2.9m at 17p in an oversubscribed placing in April 2023. 

The company aims to replace animal meat tissue with lab-grown, scaffold-free bio-equivalents. The scaffold is the structure that holds the meat together, and it is often synthetic or plant-based in lab-grown meat products, altering the texture of the meat. Tests showed that BSF’s cultivated meat was very similar in appearance to conventional meat in the raw state, and when cooked it was also consistent in terms of appearance, aroma, and tendency to sear or crisp. 

If we assume that operational cash-flow costs remain the same, then the company is likely to have enough capital for well over 12 months, allowing it time to make further progress with its products and build commercial relationships. The stock is unprofitable and so it must be regarded as speculative. But with the company also producing lab-grown animal skin for the tanners of a luxury leather goods manufacturer to test, and having sent its patented City-Mix (a supplement that boosts cell production) to several customers to test, there is ample upside if BSF can monetise its assets effectively.

5. PCI-Pal (Aim: PCIP), 50p

This company provides payment services for cardholder-not-present (CNP) transactions. It has been the subject of a lawsuit from competitor Sycurio, while a profit warning has also contributed to the recent share-price decline. 

Broker Cavendish has trimmed the company’s sales growth forecast for the year to 30 June 2024 to £19.1m from the previously expected £20m. But given the £14.9m achieved in the previous year, the company is still growing quickly and has reiterated that it expects its first full-year adjusted profit this year. 

Management believes the lawsuit was designed to put a spanner in the company’s growth, and on 25 September PCI-Pal announced it had won the case in the UK High Court. The company showed not only that Sycurio’s patent was invalid, but also that even if it had been valid, PCI-Pal’s Agent Assist solution would not have infringed it. The company is seeking a full recovery of costs in the UK, but it is not out of the woods yet, as the US lawsuit is still ongoing. Therefore, I have to regard this company as speculative and highly risky due to the lawsuit. The group is also still in the red, although this is expected to be the first full year of adjusted profit. Should the lawsuit go the wrong way in the US, then the share price could go much lower. 

However, given the current share price is only slightly above the price before the news of PCI-Pal’s total victory, I believe this risk is more than priced in.

Michael Taylor holds long positions in ALT, BBSN, RNO, AET, BSFA and PCIP. You can get Michael’s monthly Buy the Breakout newsletter for free at shiftingshares.com. Follow Michael on X (formerly Twitter) @shiftingshares.

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Small, early-stage businesses don’t generate income, right? Well, that might be true as a rule; paying dividends to shareholders is not a priority for most companies as they develop. But venture-capital trusts (VCTs), which invest in such companies, offer some remarkably generous yields. And that makes them the investment vehicle of choice for many pension savers.

VCTs paid out £556m in dividends over the year to the end of March, almost two-thirds more than in the previous 12-month period. This bumper distribution is all the more welcome as there is no income tax to pay on VCTs’ dividends.

Launched almost 30 years ago, VCTs offer investors generous tax breaks in return for providing funding for small and immature businesses. VCT managers build portfolios of investments in these businesses to spread risk, but each investee company must be worth no more than £15m, have no more than 250 employees, and be no more than seven years old.

VCTs: high risk, high reward

These are higher-risk holdings. Such businesses can – and regularly do – fail. But tax benefits provide some protection: not only do the dividends incur no levy, but profits on VCTs are also free of capital-gains tax. In addition, investors get 30% upfront income-tax relief: you can put up to £200,000 into VCTs each tax year, but that maximum investment would cost you only £140,000.

Compare this with private pension saving, where your annual contributions are capped at £40,000 each year. Moreover, there is a lifetime allowance to worry about with pension plans: tax charges kick in once your total savings exceed £1,073,000, including any investment growth. The fact that this allowance has been frozen until at least 2026 means more savers will be caught out. This is why VCTs are now attracting so much attention from pension savers, and not just those who are in the accumulation phase of planning for retirement, where the focus is on building as large a pot as possible. Because many VCTs pay decent dividends, they can be useful at the decumulation stage too, when you’re drawing down money from your savings.

But how do VCTs manage to pay out so much when the early-stage companies they invest in rarely pay any dividends at all? The trick here lies in the way VCT managers structure their support for investee companies. Very often, the investment they make is partly in the form of loan finance, rather than entirely in shares in the business. The investee company’s repayments of this money provide an income stream for the VCT.

This structure comes with the added benefit that lenders to businesses rank ahead of shareholders if the company fails; they have an earlier call on its assets, so this is a less risky type of transaction. But the real advantage here is to turn what would conventionally be an investment orientated towards long-term capital growth into a generator of regular income.

Many VCT managers are now aiming to deliver a yield of around 5% a year – worth 7% if you’re a higher-rate taxpayer – which is why dividends have climbed so steeply in recent times. Pension savers will need to choose carefully, and independent financial advice may prove valuable. VCTs come in many forms, with very different risk profiles and underlying investments. You also need the right fund for your situation. A VCT focused on generating as much yield as possible might not be right if you are still in the accumulation phase of saving. Still, the sector now offers attractive opportunities for both income and capital gains – and for those worried about pension allowances, it has extra potential when it comes to tax efficiency.

The US has been the best major market in the world since 1926. Within it, small-cap value stocks have outperformed. Armed with this fact we started our fund in 2010 to focus on small US value stocks and reap the best possible long-term rewards. What could possibly go wrong?

From 2006 until the end of last year, large-cap growth trumped all, aided by a unique set of circumstances. Even so, we jogged along, averaging a return of 15% a year, which shows this asset class is special even in adversity.

The US is the best hunting ground for small-cap stocks and our fund’s price/earnings (p/e) ratio of seven times trailing earnings is the cheapest it’s ever been. Last year we bought our first stock with a p/e of under one, building-products distributor BlueLinx. We paid $16 a share and it proceeded to earn $23 in the following year. Now it’s trading at $69, and it’s still cheap.

But isn’t it 1973 all over again, with inflation high and recession looming? If we are heading towards inflation investors are going to want low p/e ratios. Yet going into recession, you need to hide in quality, which implies high p/e ratios. So how do we resolve this paradox?

Fortunately we can look to another variable: duration. During high-growth eras, low interest rates meant investors were prepared to wait for years for companies to flourish. It didn’t matter that space rockets wouldn’t be profitable; low interest rates would take care of it. But now the crystal ball has clouded and investors are no longer willing to look so far into the future. This is a time of short duration.

Note too that the entire outperformance of small-cap value over the S&P 500 in the last 100 years occurred between 1975 and 1983, a period of high nominal but negative real interest rates that emerged from the recession of the mid-1970s. Once recession arrives, we expect this outperformance to recur amid a similar backdrop. As the cycle turns up, duration increases as investors grow more confident and discount further into the future, and away we go.

Gas demand is taking off

Short duration is usually associated with sectors such as metals and energy. Floating liquefied natural gas (FLNG) systems are positioned near wells, reduce the gas 600-fold, and then it gets shipped off in liquefied natural gas (LNG) boats.

There is a massive arbitrage opportunity between high European and cheap American gas prices now that European prices are fixed high. FLNGs, not FANGs, are in demand and Golar LNG (Nasdaq: GLNG), which designs, owns, and operates infrastructure that turns natural gas into LNG, has them.

Float your boat

Malibu Boats (Nasdaq: MBUU) produces motorboats for wakeboarders, the fastest growing part of the watersports market. The firm has quadrupled earnings per share in four years and is on a p/e of just seven. Post-pandemic behavioural change, record order books and financial strength all make the shares compelling value.

Profiting from stuffed toys

Build-A-Bear Workshop (NYSE: BBW) offers birthday teddy-bear-making parties in its stores and is expanding into the gift and mascot market, thus attracting older customers. The stock is on six times trailing earnings with a double-figure growth rate that shows no sign of slowing.

It’s been a tumultuous 18 months or so for the global economy, financial markets, and for business. The word “unprecedented” is overused. But in the case of the pandemic – and the measures taken to contain it – it’s probably the only word that fits. Thanks to the rapid discovery and rolling out of vaccination programmes, we can at least be hopeful that the worst of Covid-19 is behind us in terms of outbreaks.

However, we’re now seeing a great deal of disruption to all parts of the global supply chain, as the impact of lengthy lockdowns, quarantine measures, and ongoing complications with cross-border travel collide with a recovery in demand. The cost of everything from energy to commodities to used cars has soared, while there are signs of longer-term inflationary pressure building in the form of worker shortages and demands for higher wages.

Despite all this, share prices have rallied strongly since their nadir in March 2020. The question now is, as the recovery runs into these headwinds, what does this mean for markets and for smaller companies in general? MoneyWeek executive editor John Stepek sat down with Roland Arnold, portfolio manager of the FTSE 250-listed BlackRock Smaller Companies Trust (LSE: BRSC), to get his view.

The trust itself has been around in one form or another for more than 100 years. It has an excellent long-term track record, having comfortably beaten its benchmark in terms of both share price and net asset value total returns, over the past three, five and ten years. Arnold meanwhile has spent his entire career in UK equities, having joined BlackRock in 2000. He has been running BlackRock’s UK Special Situations fund since 2012. In April 2018 he was appointed co-manager of the Smaller Companies trust, before taking over sole management in June 2019.

“One of the most powerful things about small company investing is that these businesses tend to be more nimble,” says Arnold. “I’m working on the assumption that a large number of my companies are going to report issues with labour... with supply, with disruption – but those are short-term issues. Far more important is how they deal with it in the mid-to-long term.”

The crucial thing to remember, says Arnold, is that these are supply-side issues. That means supply will catch up before too long, and in the meantime, underlying demand remains strong, which is a long-term positive for companies. Indeed, despite the prominence of supply chain woes, Arnold believes that the industrial sector contains some of the most interesting opportunities as the world emerges into the post-Covid era.

The short-term gap between surging supply and demand represents one opportunity. But another, more lasting trend, is that as a result of the disruption caused by Covid, companies are likely to hold more inventory than in the past, as they decide that “just-in-time” is no longer the best business model. This should underpin demand in the sector for a long time to come, even after supply has caught up with the short-term backlog.

The fact that governments also went to great lengths to shield both consumers and businesses from the worst of the pandemic’s financial impact has also enabled some companies to use the pandemic to reconfigure their business models. For example, notes Arnold, in the retail sector, with furlough schemes temporarily removing a large proportion of staffing costs, some companies took the opportunity to renegotiate tenancies, and to broaden their market by increasing their sales through other channels, such as online. Those changes are now permanent and mean they will be coming out of the pandemic in better shape.

In short, there’s no doubt that the economy is facing some immediate challenges. But in the longer run, there are plenty of good reasons to be optimistic on the outlook for smaller companies in the UK. To find out more – and to get Arnold’s view on the value of meeting management teams, his take on private equity bids, and how he decides when it’s time to sell a stock – sign up to watch the entire webinar here.

Venture capital trusts (VCTs) are entering their 30s. They’ve stood the test of time, but should you consider investing in VCTs?

As vehicles that invest in private companies, VCTs don’t feature heavily in the top stocks and funds for investors. They are volatile investments, and small businesses often struggle during times of economic instability.

But with interest rates falling, the prospect of a peace deal between Russia and Ukraine on the horizon and increasing investor appetite for private assets, it could be worth considering investing in VCTs.

“There’s a lot of activity in private markets,” Robert Whitby-Smith, partner of Albion Capital, told a recent media roundtable celebrating 30 years of VCTs. “It's become a very exciting and fast growing asset class. UK enterprise is incredibly strong.

“The UK venture capital ecosystem is now larger than France and Germany combined, and we've got incredible innovation coming out of both our founders – amazing entrepreneurs that founded businesses – and also the universities within the UK.”

VCTs are a form of investment trust deliberately designed to encourage investment into small companies that require external fundraising in order to grow.

For that reason, they come with numerous tax advantages, which we will explore in detail.

“Over the last three decades, VCTs have become a fundamental pillar of the UK’s innovation economy, consistently delivering capital to the most ambitious, high-growth businesses that drive productivity, job creation and technological progress,” says Chris Lewis, chair of the Venture Capital Trust Association.

What are VCTs?

VCTs are a type of investment trust that invests in venture-funded companies. They were introduced in 1995 as a means of incentivising investment into private businesses, which is why they come with tax advantages.

“VCTs are celebrating 30 years of supporting the UK’s most ambitious smaller companies,” said Richard Stone, chief executive of the Association of Investment Companies (AIC). “They have generated thousands of jobs and boosted economic growth across innovative sectors like tech and healthcare.”

They’re a distinctive asset class in that they allow everyday investors access to private companies. These companies don’t usually trade on public stock markets (though some might be listed on Aim); in that instance, you can’t hold them in a stocks and shares ISA.

VCTs, though, make venture-funded businesses accessible to ordinary investors.

The rules on qualifying VCT investments that the funds can make are extremely strict. Usually, VCTs may only invest in businesses worth less than £15 million and with fewer than 250 staff.

These businesses must be less than seven years old and certain sectors of the economy are off-limits, notably most financial services.

The fact that VCTs spread their money across a number of companies goes some way to mitigate the risks of investing in small, early-stage firms like these.

Investors should be under no illusions, though: these are immature and fragile businesses with plenty of potential for failure.

Like all investment trusts, VCTs are themselves listed companies that trade on stock markets. Their entire remit is to invest in assets – in the case of VCTs, these are venture-funded companies.

Investment trusts can (and usually do) trade at a discount to their net asset value (NAV). With private companies being inherently hard to value, this can mean that the value of the shares you buy or own in a VCT can become significantly detached from the valuations of their assets.

What advantages are there to investing in VCTs?

As well as offering access to otherwise inaccessible companies, VCTs offer several tax incentives to investors.

This includes 30% upfront income tax relief on investments into new VCT shares, provided these are held for at least five years. So for every £10,000 you spend, up to £200,000, you can take £3,000 off your income tax calculation.

That only applies to investments in new shares – those issued when the trust is formed or when it raises new capital. VCT shares bought in public markets won’t qualify for income tax relief.

If you sell shares on which you claimed income tax relief within five years, you’ll need to repay whatever tax relief you received.

However, all VCT shares qualify for tax-free dividends, and if you sell any VCT shares at a profit you won’t need to pay capital gains tax (CGT).

“Over time, financial advisers and wealth managers have increasingly recommended VCTs as a tax-efficient investment strategy, expanding their popularity,” said James Hendry, investment director at Gresham House Ventures.

That said, the tax relief on offer should only be part of the equation when determining whether to invest in a VCT, suggests Joshua Gerstler, owner of The Orchard Practice.

“As the investments are in start-up businesses, they are high risk and although the tax incentives are generous, there is a risk of losing all of your money. You should invest in a VCT because you like the investment, not just to save tax,” he says.

Why might now be the time to invest in VCTs?

First of all, it’s important to remember that all investing involves risk. VCTs in particular should be viewed as long-term investments, given the nature of the companies that they invest in.

Smaller, growth-oriented companies are typically risky investments. Many would argue that the current economic climate isn’t conducive to this kind of investing.

Interest rates are relatively high, which increases borrowing costs for smaller companies, and persistent inflation – which could ramp up should president Donald Trump’s tariff regimes disrupt global trade – can deter investment in smaller companies. These firms are often dependent on this external capital for growth.

That’s reflected in the performance of VCTs in the last three years; on average, they have fallen 4.6% over the past year and 16.1% over the past three (to 31 January 2025) according to data from the AIC.

However, periods of adversity often nurture success stories.

Whitby-Smith points out that “if you look at the most successful companies in the world – Apple, Microsoft, Amazon, Nvidia, Uber – often they were founded in difficult economic periods, and that did not hamper their overall success”. He adds that it may even have contributed to it.

Over the long term, VCTs have performed more strongly, gaining 57.7% in the ten years to 31 January and 218.9% in the twenty years to then.

“While broader economic uncertainty persists, the demand for VCTs continues to reflect their role as a stable and established investment vehicle,” says Lewis.

“Investors remain drawn to the combination of growth potential, diversification and government-backed tax incentives, reinforcing VCTs as a key mechanism for funding UK innovation."

Do VCTs trade at a discount?

VCTs currently trade on an average discount rate of 9%. AIM Quoted VCTs trade at 6%.

Discounts aren’t necessarily a particularly useful metric to apply to VCTs, though.

“VCT shares are not normally bought and sold in the secondary market,” explains Nick Britton, research and content director at the AIC.

While “there are sometimes interesting trades to be had buying VCTs in the secondary market, if they are heavily discounted… the problem is that you don’t get the 30% upfront income tax relief.

“For that reason trading of VCTs in the secondary market is a minority sport.”

He adds that individual investors are better-off looking at VCTs’ share buyback schemes, “whereby shares are bought back by the VCT at regular intervals at a set target discount (say 5%)”.

Three top-performing VCTs

Taking a long term view is central to most investing. That’s particularly true when considering investment trusts, and even more so with VCTs.

Given the tax incentives, any investment into a VCT should consider at least a five-year time span, and we’ve extended that out even further, considering VCT performance in the ten years to 31 December 2024. All data is from Morningstar via Wealth Club.

^{Source: Morningstar via Wealth Club}

Remember, past performance is not a reliable indicator of future results.

Both Mobeus Income and Growth (LON:MIX) and British Smaller Companies (LON:BSV) invest in emergent UK businesses – in MIX’s case, unlisted ones in particular.

Albion Enterprise VCT (LON:AAEV) was the first institutional investor in Booking.com and has a focus on B2B software. “What’s different about us is the focus that we’ve chosen and the expertise, the skills and experience we’ve learned within those sectors,” Whitby-Smith told the media roundtable.

You might be beginning to feel the sands shifting slightly beneath your feet. Nothing is quite what it used to be – or is supposed to be.

The Conservative government is not a conservative government; it has just announced a 1.25 percentage point tax rise on earned income and on dividend income and expects the money raised to finance a “permanent new role” for the state.

The Bank of England seems less solid than it used to be as well. Its endless money printing increasingly confuses fiscal and monetary policy, and most observers reckon the main aim of quantitative easing is now to finance government spending. It spends a lot of time commenting on matters that don’t seem core to its purpose – the bank is supposed to care about inflation, not climate or inequality.

Then there are our big companies. Once they thought about profit; now they think a bit about that and a bit about things such as social engineering. Witness KPMG’s announcement this week that it is to categorise its employees by class. It’s not quite the shareholder capitalism in a liberal democracy vibe we like to think we are used to. It’s also just a little bit 1970s.

We’re not back in the 1970s quite just yet

It was the lack of central-bank independence in the 1970s that, in part at least, gave us the inflation almost everyone now appears to have forgotten. The governments of the 1970s are also remembered for their high spending and high tax policies.

We have a way to go to meet the economic madness of that time – although the Tories’ brand new tax has echoes of the 1978 2.5% National Insurance surcharge on employers and the 15% investment income surcharge of 1972 (finally abolished in 1984).

We also aren’t quite at the point when a dividend tax is used as a clumsy sort of wealth tax, as was the case in 1948 when the chancellor put in place a whopping new levy on investment income: 10% on the first £500 (£18,500 today) rising to 50% on anything over £5,000 (nearly £2m today – so really one for the wealthy only).

It’s also true that the government has made it very clear (again) that our houses are sacred. Regardless of the fact that, in the main, our kids will flog them the second they get probate (the only delay being the many months it now takes to get it), the myth that the family home is somehow emotionally superior to all other assets is to be maintained. Much the same goes for buy-to-let – there’s no new levy on property income. Still, the new levy on dividends is a line in the sand, a reminder that murmurings about the need for a wealth tax aren’t going away.

Fashions change, but the rationale behind investing remains constant

What do you do at times of such institutional shape shifting? The way to start is to remember the constant of investing – and the nub of rationality behind all valuation techniques – all equities are valued on the basis that they will provide an income to someone at some point. That might be you now, it might be you in the future, or it might be someone else in the future.

Either way, the price of the share reflects the expected time period in which such an income might appear and the expected scale of that income. So even when we pay fortunes for Tesla shares, we aren’t chucking our money at the business as some kind of tribute to the gods of innovation. We are doing it because we expect that one day the innovation we have financed will turn into a tsunami of cash. Our capital gains are simply rolled up long-term income expectations, that’s all.

In excitable times, too many people forget this dynamic and indulge in what we might call tribute investing. You don’t want to do that (it ends in tears, always). Instead you want to invest in companies that you know are producing or have some certainty will produce the income you are after and perhaps mildly favour those that will give it to you in the future. Unless you hold everything in a self-invested personal pension or Isa, the tax on capital gains is kinder than that on income – something that makes a bird in the hand no longer look quite like two in the bush.

What to buy now: UK small-cap stocks

With that in mind I think it is worth looking again at the higher-quality end of UK smaller companies. Small-cap stocks as a whole have had a tremendous year – the FTSE Small Cap Index is up nearly 50% in the last year. And small-cap stocks are still benefiting nicely from the recovery in the UK (clouded slightly by supply problems) and they also look pretty inexpensive relative to the rest of the market, which is in itself cheap overall both in terms of historical averages and international comparisons.

The median FTSE 100 price/earnings (p/e) ratio is 16.5 times, that of the FTSE 250 is 19.6 times and that of small caps 15.3 times. Joachim Klement, an investment strategist at Liberum, an investment bank, points out that the FTSE 250 has been hugely boosted by takeover bids for some of the index’s “heavyweights” such as Wm Morrison and Meggitt. However, even with these taken out, these larger companies trade at a premium to smaller companies.

This makes little sense given the extraordinary performance of some of the UK’s smaller companies during the pandemic, says Anna Macdonald, a fund manager at Amati Global Investors, who I spoke to for this week’s MoneyWeek Podcast (listen to that here).

Macdonald points to homeware retailer Dunelm, which this week announced its profits were up 44% and that its shareholders are to get a 65p a share special dividend. It isn’t madly cheap (on a forecast p/e of 18 times for 2022) but there is more growth to come, she says, and probably more special dividends too. Birds in the hand and in the bush – that makes it exactly the kind of thing you want to hold (preferably in your Isa or Sipp to avoid dividend taxes).

There are things to worry about in the world of small-cap stocks. Liberum says it is increasingly concerned about the “lack of breadth” in the market in that the share of stocks outperforming the index is low, which it says is sometimes an indication that a “short-term correction is on the way”.

Luckily, we individual investors need not be concerned about short-term corrections, since no one is judging us on a quarterly basis. Funds to look at include the Amati UK Smaller Companies fund and the Standard Life Smaller Companies Trust (LSE: SLS). The latter has slightly underperformed recently, due to its focus on high-quality growth companies, but it now trades at a discount to its net asset value – and the manager has an excellent long-term record.

The sands may be shifting but there are still excellent opportunities in UK markets – unless, of course, we do end up back in the 1970s.

• This article was first published in the Financial Times

It’s hard to believe it’s been six months since I wrote Five Aim stocks with plenty of potential for 2021 (27 December 2020). We’re now closer to next Christmas than the miserable last one. But money never sleeps – and neither should you when it comes to stock picking. The market moves constantly. Being asleep at the wheel is a cardinal sin when managing your own money.

The five stocks I picked in December have done well. Four have risen and two have doubled. It would be easy to proclaim my own genius, but the reality is that all stocks have performed strongly. What’s more, these are investment ideas, and rarely does an investment thesis play out over a six-month sprint. Let’s look at how they have performed before moving onto four ideas for the second half of 2021.

How my five picks from December 2020 have done

Anglo Asian Mining

(Aim: AAZ) 127.5p, now 143.5p

A modest 12.6% increase in price suggests little has changed at this Azerbaijani copper, gold and silver producer. But a five-year extension to its Gedabek contract area has been approved, while 2020 saw record revenues and strong cash generation. The company believes it has “exceptional development opportunities” in its six contract areas.

I sold out of the firm because I believed there was faster money to be made elsewhere. I’m a trader and if there are better opportunities somewhere else I have to chase them. But the investment thesis is stronger than ever and Anglo Asian has entered 2021 in fantastic shape. Shareholders may need to be patient for a catalyst to appear to drive the share price higher. I have not ruled out buying back and will continue to monitor the stock closely.

Cloudcall

(Aim: CALL) 88p, now 65p

This is the only stock of the five that has fallen. I must admit I got this wrong. I underestimated the effect that Covid-19 would have on the company. My initial belief was that working from home should be great for Cloudcall because it is a telephony-solutions business. But growth has been slow and will remain pedestrian even though it’s a cloud-based scalable platform.

The company thinks it can reach revenue growth of 25% in 2022 and it is targeting EBITDA breakeven during 2023. It’s unfair to blame management for the virus, but with the growth story pushed back further it’s also not unfair of me to sell. Cloudcall executed a brilliant fundraising in the period. It scooped up approximately £6m, highlighting the strong institutional support for the business.

The upshot? I’m happy to keep this stock on my watchlist. I don’t mind buying it higher if growth starts increasing faster than expected. With a market capitalisation of £31m, the stock’s upside potential is high – but for now I believe there are faster returns elsewhere.

Cambridge Cognition

(Aim: COG) 56.5p, now 142.5p

The stock of this specialist in neurological disorders (its software measures cognitive function) has almost tripled since I tipped it. The company has delivered revenue growth and more contract wins and so I’ve increased my holding several times. I said in December that Cambridge Cognition should be profitable and self-sustaining soon.

It was confirmed in March that the last quarter of 2020 was profitable and the firm is now adding to its cash position comfortably from its operations. Renowned investor Peter Lynch wrote that selling winners and adding to losers is like watering your weeds and pulling out the flowers. Although the shares have risen significantly I still believe the upside is high and I see no reason to sell out.

Escape Hunt

(Aim: ESC) 16.5p, now 39p

This company has been a stellar performer in 2021. Traders should always be looking for asymmetric risk-reward scenarios, where the reward far outweighs the potential loss. When I took the placing at 7.5p in May 2020, everyone had written this provider of “escape room” experiences off.

People were saying “hospitality is dead, retail is done” – yet Escape Hunt had raised enough cash to see itself through the next 12 months. I thought that if the Covid-19 situation was indeed as bad as everyone assumed and didn’t improve, the downside would be at least 50%. But if the Covid-19 situation was better than the market thought and improved, then the upside was potential multiples of the price.

Even when Escape Hunt raised capital to acquire its French master franchise partner BGP Escape at roughly its average unaudited EBITDA for 2018 and 2019 and we were actively rolling out a vaccine, the market was still fast asleep. I added more to my position in the placing and more in the open market.

At 39p, I’m up by 400% on my original purchase price and have sold some shares to book profits on what is a fantastic gain. I believe there is more to come from the company although I expect the shares to consolidate and trade sideways after such a bull run. I remain a happy holder having taken some profits.

Smartspace Software

(Aim: SMRT) 140p, now 165p

My final pick, Smartspace Software, which makes programs to help companies with office administration, such as booking meeting rooms or desk space, was originally going to be at 100p. But in the week between the article’s submission and publication, a tip sheet also spotted the potential here and pushed the price up to 140p.

This annoyed me because even though the stock was still a buy at 140p, it meant that you as the reader had missed out on 40% upside. I’m still holding Smartspace, but the valuation is now verging on rich. I believe this company is going to continue to win business and grow, and I remain a holder.

These ideas have done reasonably well. I’d be delighted if you had done your own research on these stocks and saw some benefit. Remember, investing in Aim companies always carries risk, but as we can see the rewards are substantially higher if you pick the right stock.

Four more potential winners for the second half of 2021

PCI-Pal

(Aim: PCIP), 81.5p

PCI-Pal provides payment solutions for card not present (CNP) transactions. The company is focused on contact centres (like call centres but also including emails and interactions on websites), which are becoming increasingly omnichannel and solve the problem of handling and storing customers’ data securely. This is a real problem for its clients because under GDPR and other data regulation frameworks the cost of breaches or misuse can be seriously damaging – both financially and reputationally.

It therefore makes sense for clients to outsource this risk to a payment card industry data security standard (PCI DSS)-approved provider so they can focus on their own core competencies. PCI-Pal is now embarking on a land-grab strategy, which I believe has the potential to generate multi-bagger returns. The company raised £5.5m at 95p in April to accelerate the rollout and open up new markets. Since then, PCI-Pal has announced that revenue for the full year will be 5% ahead of market expectations and about 60% higher than last year.

What I like about this company is that it is almost cash flow-positive at these levels. Profitability has been pushed out further because of the accelerated growth strategy, but this makes sense in a market that is very much up for grabs. Gunning it to be the main player is a sensible strategy here in order to scale up and dominate.

PCI-Pal uses a channel-focused (using a middleman to distribute a product) sales approach that is different from that of its competitors. One risk here is that channel partners decide to go their own way (I believe they will in time), but for now the likes of Salesforce are happy to recommend PCI-Pal’s products to their own clients.

The potential market has around 80,000 contact centres, of which PCI-Pal so far has fewer than 500. Contrast this with the current market value of £53.5m and the potential upside is clear if management can execute effectively (there’s always a risk that it can’t). The global footprint for PCI-Pal is expanding and I hope as a shareholder that the stock price will expand with it.

Guild Esports

(Aim: GILD), 6.75p

Guild Esports is the first London-listed esports organisation and the first to list on a major exchange globally. Many have been sceptical about esports – saying “video games aren’t a sport”. The stereotypical view of a gamer is of a geek who lives in his mother’s basement. However, darts is hardly the peak of athleticism either; or take golf – where you walk around all day and hit a ball every now and again (and someone else carries your clubs).

Professional gamers today have coaches, managers and even nutritionists. People come to watch them compete against each other in arenas. David Beckham is a shareholder in Guild and the new academy the company has brought in to develop and nurture talent is built on the footballing model. The opportunity here is for the business to create a brand that other brands wish to be associated with. However, there is no denying that the value of these sponsorships could easily fluctuate upward or downward depending on the performance of the teams Guild puts out. Naturally, my hometown football club of Hartlepool United is unlikely to be attracting luxury brand sponsorships anytime soon. But top players and top teams can command premium deals, so Guild aims to grow its audience by keeping a roster of high-quality talent and monetising that brand through commercial sponsorships.

US esports giant Faze Clan has hired a chief strategy officer with an eye for targeting luxury brands. Guild has signed a two-year multi-million pound deal with Subway, and has hinted at more to come. Guild Esports is not yet profitable – and there is no guarantee that it will be. But with a market value of £35m and £18m in net cash on the balance sheet as of 28 January 2021, the risk here is to the upside should the group deliver on its sponsorship goals.

Transense Technologies

(Aim: TRT), 77.5p

Transense Technologies makes sensor systems measuring torque, pressure and temperature for industries ranging from renewable energy to aviation. It has been listed on Aim since 1999, but has never made a profit. It is an interesting example of how shareholders can fund stakeholder spoils for years without seeing any return for themselves. Directors get their salaries and advisers, brokers and PR companies are all paid for by the company.

But Transense is a classic example of the facts changing and the market being slow to respond. Two years ago, the company gave away its iTrack technology to a subsidiary of Bridgestone, the lorry and car-parts maker. There was a sense that the company had given away the golden goose as it was simply transferred to the company in exchange for royalties. I admit to thinking so. However, to market a technology such as iTrack would require significant upfront capital investment. By transferring it to Bridgestone and receiving income from licensing, Transense receives a pure profit and eliminates overheads and capital investment.

Royalty income in the second half of 2020 totalled £370,000. This is expected to increase as Bridgestone has launched its new MasterCore tyres for large mining vehicles and sells its iTrack technology alongside this. Even if the company didn’t see any expected growth in revenue and only received £700,000 per year for the next ten years, that would be cash that covers more than half the current market capitalisation of £12.6m.

But there are another two parts of the business. Transense’s surface acoustic wave (SAW) technology has also secured a licensing deal to go into GE Aviation’s T901-GE-900 engine, which has been picked by the US Army to re-engine its Apache and Black Hawk helicopters. Royalties are expected to come online in 2023-2024, but of course there are many things that could still go wrong.

The final third and small business Transense owns is a tyre-probing unit. Management claims to be focusing on it now to commercialise it. My belief is that the Bridgestone deal buys the company ten years to drive value elsewhere. With a new chair and the board now buying shares regularly, I am long.

Brand Architekts

(Aim: BAR), 173p

Beauty-products group Brand Architekts was previously called Swallowfield. The business has been completely reset with a sale of the old manufacturing business and a fresh board. It’s now a higher gross-margin company selling its own products.

Its valuation of £29.8m is bolstered by a £19m cash position – an improvement of £1m from the previous year. This shows there are no solvency problems, but the turnaround is still in its early stages. Management has revitalised the brands and is focusing on profiting from the 50% sales growth in skincare label Super Facialist and the direct-to-consumer platform, which is due to launch in July.

The downside here is that there is a large pension deficit on the balance sheet. I have never heard of a company going bust because of a pension deficit (and especially not when it is so flush with cash), but it is something to be aware of. I’m comfortable with this risk and I think this issue will be dealt with should management execute effectively.

Why you should read always annual reports

No matter how good a stock’s story sounds, always go through the financial statements properly. Many people spend more time trying to save £50 on a television than they do on researching where they’re putting their hard-earned cash. Is it any wonder some investors lose money? Management teams are well aware of this and along with trying to shift debits from the profit and loss statement into a credit on the balance sheet, they will hide what they don’t want you to see where they know you won’t look: their annual report.

Before investing in any company, you should take some time to go through at least the most recent annual report. I like to print the two most recent annual reports and read the older one first so I can get a feel for the story. Reading the latest one last also reveals whether management actually succeeded in executing the strategy they outlined the year before.

One of the important parts of the annual report is the notes to the financial statements. This is where revenue and segmental breakdowns are explained, as well as the reasons for laying out the accounts in the way they are presented. You don’t get this in the half- or full-year results, so this is essential reading.

I always like to check the remuneration part of the report to see if managers are aligned with shareholders. If executives’ pay rises significantly year-on-year with the share price achieving little and management owning almost no or zero stock, then this saves me a lot of time. I avoid the stock completely.

For more market insights you can get Michael’s “Buy The Breakout” monthly newsletter at www.shiftingshares.com/newsletter

Disclosure: Michael holds long positions in COG, ESC, SMRT, PCIP, GILD, TRT, and BAR.

“The smaller, the better,” says the London Business School, which has examined the performance of smaller companies since 1955. The compound annual return of the Numis Smaller Companies index, representing the bottom 10% of the UK market, has been 14.7% since then, 3.4% ahead of the All-Share index. The yearly return of the Numis 1000, representing the bottom 2%, has been 16.3%.

Excluding investment companies, there are over 100 listed “micro-cap” companies with market values below £100m, but they only account for 0.2% of the total market by value. Another 50 have market values of £100m-£200m, adding 0.4% of total market value, but the inclusion of listings on Aim, the junior market of the London Stock Exchange, trebles the number of stocks.

Scouring this mass of tiddlers for bargains are two trusts, the River & Mercantile UK Micro Cap Investment Company (LSE: RMMC), launched in late 2014, and the Miton UK MicroCap Trust (LSE: MINI), launched a few months later. Both have assets of a little over £100m; target firms with a market value below £150m; and trade on discounts to net asset value (NAV) of around 3%. However, George Ensor, manager of RMMC, points out that his trust has also returned capital to investors four times, £57m in total, in order to limit its size. It has just 41 holdings and without that limit would have to increase that number or have larger and less liquid holdings. Gervaise Williams, MINI’s manager, is happy with 128 holdings.

The tortoise and the hare

It’s been a story of the tortoise and the hare. RMMC raced away under its first manager, who was then forced to leave owing to an obscure compliance issue. Its investment return has been 143% over five years and 44% over one. MINI has returned 94% over five years, but 92% over one. Both trusts struggled in 2018-2019, but MINI, with a strong bias towards value, struggled more. Having withstood the sell-off in early 2020 better than RMMC, it has since soared. This is probably due to Williams’s focus on “highly cash-generative stocks”.

Choosing between them is tough. Ensor is clearly finding his feet, but lacks Williams’s 30 years of experience. Inevitably, both trusts are full of stocks few people will ever have heard of. Ensor has moderated the growth focus of his predecessor: “growth is important, but we don’t want to overpay for it”. Williams notes that “it’s important not to get carried away by a good story”, though his exposure to information technology companies is, at 14%, ten percentage points higher than Ensor’s. By contrast, Ensor’s exposure to the consumer and healthcare sectors is 32% compared with 17% for Williams.

Unparalleled choice in the UK

Williams sees particular opportunity in “the cyclicality of various financial and commodity micro caps, providing greater upside at a time of recovery from the pandemic. The potential could be even greater if [inflation takes off]. They have been out of favour for so long that it is easy to underestimate the full scale of their upside”. He has pushed exposure to these sectors up to about 40% of the portfolio compared with 32% for RMMC.

Neither trust has any borrowings and both have plenty of cash. As to the outlook, “what remains curious is how easy it is to find attractively valued companies capable of compounding value for shareholders over a multiyear horizon,” says Ensor. “The UK stockmarket is possibly unparalleled from this perspective.” Williams thinks that the low valuations of micro caps provide “better potential for recovery than other areas of the market” and thinks they could be “at the start of a brand-new supercycle”. This corner of the UK market is easily ignored, but promises rich returns for investors in either trust.

US markets are replete with dynamic technology companies; Europe’s are staid and boring. Or so many investors think. But this is not entirely accurate. On the continent, for instance, tech companies now boast a bigger market capitalisation than banks and energy companies.

In Britain, on the other hand, investors seeking burgeoning, earlier stage businesses tend to go for the private firms found in listed portfolios such as the Chrysalis investment trust, which has been a top performer in recent years. However, there is also the long-established venture capital trust (VCT) sector. According to investment services group Wealth Club, these tax-efficient listed funds are increasingly investing in the same kind of fast-growing, valuable companies you’d expect to find in the Chrysalis fund and bigger rivals such as Baillie Gifford’s Scottish Mortgage trust.

Targeting fast growers

In 2015 changes to the VCT rules required all new VCT investments to be made in younger companies seeking growth capital. Since then, VCT portfolios have started to catch up with the reality that the UK is Europe’s top market for scale-up firms (those with more than ten employees and growing sales by at least 20% a year). A record £10.1bn was invested in UK technology companies in 2019; 81.2% of this went into high growth, high productivity scale-ups. According to Jonathan Moyes, head of investment research at Wealth Club: “If you look at many of the VCTs today they are arguably full of exactly the types of companies you want to be invested in, ie, fast-growing tech-enabled businesses whose business models have been accelerated by Covid-19”. Moyes divided ten VCTs’ constituents into three categories: those experiencing a decline in revenue; companies with revenue growth of 0%-25%; and finally, firms with sales growth of over 25%.

Nearly half (45.7%) of the invested assets of the VCTs are in companies growing revenues by more than 25% year on year, on average. By comparison, just 4.6% of the largest 350 constituents of the UK main market have achieved this. About 22.5% of the invested assets of the VCTs are in companies that have grown revenues by over 50%, compared with just 2% for the UK main market.

Another way of gauging this transformation is to look at the Fast Track list of the 100 UK tech firms with the fastest-growing sales over the past three years. VCTs have invested in 15 of them. They include number seven, Elvie, a female-health technology developer, owned by the Octopus Titan VCT (LSE: OTV2), and number 21, Matillon, Britain’s take on Snowflake, the cloud-based data-storage company, owned by the British Smaller Companies VCT (LSE: BSV). Personalised stationery retailer Papier, number 28, is a holding of the ProVen VCT (LSE: PVN).

Generous tax relief

Crucially, that focus on growth businesses comes with all the tax benefits of a VCT. Investors receive up to 30% income-tax relief on the initial investment; £60,000 income-tax relief on the full VCT allowance of £200,000. Any dividends and capital gains are also tax-free. Investors can sell their stake in a VCT after the five-year minimum holding period, reinvest the proceeds in another VCT and receive a further 30% income-tax relief.

Of course, investors get those tax benefits because this is high-risk stuff. Moyes concedes that “VCTs are without doubt risky. They invest in early stage businesses that often fail and VCTs... are pretty illiquid. However, when you are exposed to... 70 or even 100 companies (as is the case with some of the larger VCTs), that risk is mitigated, especially if you... invest over a number of different VCTs each year.”

And despite the changes in portfolio composition, there are still plenty of businesses that are a tad pedestrian in growth terms. Moyes says “over time we expect mature investments to be gradually sold down, and for new early stage high-growth investments to become an increasingly dominant part of a VCT portfolio. In the meantime, those older-style investments can help to

manage risk and support dividend payments.”

Aim VCTs could hit the target

Note too that many of the fund management firms that focus on VCTs aren’t exactly in the top tier of global venture-capital firms and funds, both in the tech and life-sciences sectors. Outfits such as Draper Esprit and Baillie Gifford have a world-class reputation for bringing unicorns to the main markets. In particular I would also emphasise that in the life-sciences, where the UK has a fantastic reputation, specialists such as Syncona – a listed UK fund – probably have access to deals that many VCT specialists would never see.

Then again, perhaps I am being a little too harsh. The Aim VCTs in particular have a sterling record of investing in listed biotech firms. We saw gains in net asset value (NAV) of between 20% and 40% in 2020 for the likes of the Amati Aim VCT (LSE: AMAT), where life-sciences businesses comprise 31% of the portfolio, and the Unicorn Aim VCT (LSE: UAV), 27%. Around 30% of the Hargreave Hale Aim VCT (LSE: HHV), meanwhile, is in healthcare.

If these funds keep thriving I’d expect the VCT sector to attract more attention. With just 20,000 individuals claiming income-tax relief on VCTs last year, there’s a long way to go to build market share among additional and higher-rate taxpayers.

For much of 2019, smaller companies continued to lag larger companies, as they had in 2018. Smaller companies are more geared to the domestic economy than their bigger counterparts and last year many investors were worrying about the outlook for the UK. What’s more, the Woodford fiasco raised concerns about the liquidity of open-ended funds, causing many of them to reduce exposure to small-cap stocks.

But in the last quarter, and especially in December, the clouds lifted and share prices surged. Over the whole of 2019, the Numis Smaller Companies index (NSCI), comprising the bottom 10% of the UK market, returned 22.3%, 5% ahead of the FTSE 100. But if investment companies are excluded – a gauge known as the NSCI (XIC) – the gap increases to 7.9%. The Aim market returned 15%.

A shrinking market

The NSCI comprises all 696 companies (of which 350 are investment companies) with a market value below £1.68bn and has a total value of £261bn. Including Aim, the number rises to 1,547 companies with a total value of £345bn compared with the £2,018bn value of the FTSE 100 index.

Over time, the number of companies has been shrinking, but the size of the companies has become larger. The 346 NSCI (XIC) companies have an average market value of £444m compared with 1,067 companies and an average £24m in 1987. In 1955 the respective figures were 2,517 and £0.4m.

The small-cap investment manager has more – and riskier – companies to research than the large-cap manager, each with far less coverage and less accessible management. It wouldn’t be worth bothering unless smaller companies outperformed larger companies over the long term. And they do.

According to research by Professors Paul Marsh and Scott Evans of the London Business School, the long-term outperformance of the NSCI (XIC) is an annual 3.3% over the 65 years since 1955: 14.8% per annum versus 11.5% for the All-Share index. This outperformance is replicated in most countries. The global small-cap outperformance has averaged 4.2% since 2000.

Following such strong performance, UK smaller companies ceased to be undervalued in 2019. The professors estimated that their price/earnings multiple had increased to 14.9, well above the long-term average of 12.8 and only slightly lower than the multiple for the All Share index, though low bond yields justify higher multiples. The valuation of smaller companies relative to larger ones had not reached the extremes seen in 2007, but continued outperformance needed superior earnings growth.

Discounts have fallen fast

Investors in small-cap investment trusts benefited in 2019 from falling discounts to net asset value. These averaged over 10% at the start of the year, but the mainstream trusts, such as Aberforth, BlackRock, Throgmorton, Henderson, Invesco Perpetual, JP Morgan and Standard Life were trading at, or very near to, premiums to asset value at year-end, as were the three mid-cap trusts.

Moreover, their net assets continued to outperform the NSCI (XIC), often by large margins; in Standard Life’s case by 19% and JP Morgan’s by 25%. Of the 16 trusts in the UK mid-caps and small-cap sectors, 11 returned over 40% and five over 50%.

The upshot? Liquidity worries are making it difficult for open-ended funds to own the smallest companies and Aim stocks, giving closed-end funds (investment trusts) a competitive advantage. Throw in continued strength in the NSCI (XIC) and at the start of this year respectable, though lower, returns from the mainstream mid- and small-cap trusts looked likely. And now, after February’s sharp setback, the sector again looks good value.

Each week, a professional investor tells us where he'd put hismoney. This week: Francesco Conte of the JPMorgan European Smaller Companies Trust picks three winners.

The global market backdrop appears challenging, but we are keen on European smaller companies owing to a positive outlook for earnings growth combined with market valuations close to long-term averages. The JPMorgan European Smaller Companies Trust seeks out dynamic companies with strong growth prospects that are independent of the economic cycle. Many of these tap into exciting structural growth themes such as environmentalism, ageing populations, wellness and digitalisation.

High importance is placed on environmental, social and governance (ESG) issues. Well governed companies that respect the environment and nurture their employees as well as wider society are more likely to generate sustainable earnings in an ever more competitive global environment. Here are three stocks that tick these boxes:

Falck Renewables: the future of energy

Falck Renewables (Milan: FKR)

Incredible technological progress has resulted in huge efficiency improvements in solar and wind power generation over the last decade and this is expected to continue. In many regions renewable energy generation is now cheaper than its conventional counterpart, while the demand for renewable energy continues to climb. Falck has a large development pipeline, resulting in extremely attractive long term growth prospects.

AAK: aplay on healthier eating

AAK (Stockholm: AAK)

The strong management team has a fantastic record of delivering consistent organic sales growth, margin expansion and selective acquisitions. AAK has developed strong relationships with clients through co-development of niche, technically advanced products. This supports the company's pricing power, helping it deliver a high return on capital.

Bravida: environmentally sustainable buildings

Bravida (Sockholm: BRAV)

The company's asset-light business model allows it to generate strong free cashflow, which it uses to reinvest in new growth opportunities. Bolt-on acquisitions have complemented the company's high organic growth potential. We believe that the company's excellent long-term outlook is not reflected in its attractive valuation.

Ollie Beckett, manager of the TR European Growth Trust, explains why he believes European smaller companies are performing well; Ollie believes this is due to renewed investor confidence as economic data points towards a stabilisation and a positive start to 2020. Ollie also discusses the latest portfolio activity and which stocks have performed exceptionally well.

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These are the views of the author at the time of publication and may differ from the views of other individuals/teams at Janus Henderson Investors. Any securities, funds, sectors and indices mentioned within this article do not constitute or form part of any offer or solicitation to buy or sell them.

Past performance is not a guide to future performance. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.

The information in this article does not qualify as an investment recommendation.

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Glossary

Important information

Please read the following important information regarding funds related to this article.

Before investing in an investment trust referred to in this document, you should satisfy yourself as to its suitability and the risks involved, you may wish to consult a financial adviser.

Past performance is not a guide to future performance. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested. Tax assumptions and reliefs depend upon an investor’s particular circumstances and may change if those circumstances or the law change.

Nothing in this document is intended to or should be construed as advice. This document is not a recommendation to sell or purchase any investment. It does not form part of any contract for the sale or purchase of any investment.

Issued in the UK by Janus Henderson Investors. Janus Henderson Investors is the name under which investment products and services are provided by Janus Capital International Limited (reg no. 3594615), Henderson Global Investors Limited (reg. no. 906355), Henderson Investment Funds Limited (reg. no. 2678531), AlphaGen Capital Limited (reg. no. 962757), Henderson Equity Partners Limited (reg. no.2606646), (each registered in England and Wales at 201 Bishopsgate, London EC2M 3AE and regulated by the Financial Conduct Authority) and Henderson Management S.A. (reg no. B22848 at 2 Rue de Bitbourg, L-1273, Luxembourg and regulated by the Commission de Surveillance du Secteur Financier). We may record telephone calls for our mutual protection, to improve customer service and for regulatory record keeping purposes

Specific risks

• If a trust's portfolio is concentrated towards a particular country or geographical region, the investment carries greater risk than a portfolio diversified across more countries.

• Where the trust invests in assets which are denominated in currencies other than the base currency then currency exchange rate movements may cause the value of investments to fall as well as rise.

• Most of the investments in this portfolio are in smaller companies shares. They may be more difficult to buy and sell and their share price may fluctuate more than that of larger companies.

• This trust is suitable to be used as one component in several in a diversified investment portfolio. Investors should consider carefully the proportion of their portfolio invested into this trust.

• Active management techniques that have worked well in normal market conditions could prove ineffective or detrimental at other times.

• The trust could lose money if a counterparty with which it trades becomes unwilling or unable to meet its obligations to the trust.

• Shares can lose value rapidly, and typically involve higher risks than bonds or money market instruments. The value of your investment may fall as a result.

• The return on your investment is directly related to the prevailing market price of the trust’s shares, which will trade at a varying discount (or premium) relative to the value of the underlying assets of the trust. As a result losses (or gains) may be higher or lower than those of the trust’s assets.

• The trust may use gearing as part of its investment strategy. If the trust utilises its ability to gear, the profits and losses incurred by the trust can be greater than those of a trust that does not use gearing.

• Derivatives use exposes the trust to risks different from, and potentially greater than, the risks associated with investing directly in securities and may therefore result in additional loss, which could be significantly greater than the cost of the derivative.

• If the trust seeks to reduce risks (such as exchange rate movements), the measures designed to do so may be ineffective, unavailable or detrimental.