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.
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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%.
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