Is this area of UK market one investors should focus on?

An area of the UK stock market that carries low valuations, is stacked with well-respected household names, and has been the increasing focus of international private equity and trade buyers...if that type of opportunity existed today, investors would be piling in, wouldn’t they?

Apparently not. Despite boasting all these qualities, the UK’s small- and mid-cap sectors remain persistently and possibly irrationally unloved.

“All the green lights are on,” says Gervais Williams, manager of the Premier Miton UK Multi Cap Income fund and Diverse Income Trust Ord (LSE:DIVI), of this part of the market. He’s got a point. On almost any measure, this part of the market looks like a bargain.

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Recent research from Robeco’s Quant Equity Research team suggests that on a pure earnings growth and valuation point of view, UK small- and mid-caps should be getting a closer look. It showed that more than any other area, small-caps had delivered strong earnings growth, but not been rewarded with share price performance.

Earnings growth estimates suggest that mid-caps will deliver around four times the growth of their FTSE 100 peers in the year ahead, yet trade more cheaply. Williams says: “The UK stock market appears to be an undemanding valuation, and UK-quoted smaller companies appear to be even cheaper.”

The lights are flashing green

There’s also been plenty of interest in this part of the market from international buyers, who recognise a steal when they see one. Jean Roche, manager on Schroder UK Mid Cap Ord (LSE:SCP), says there have been a raft of acquisitions, including for well-known names such as Britvic and Redrow. Acquirers have been bargain-hunting private equity groups or trade buyers. She continues to see takeover interest in stocks in her portfolio.

At the same time, companies are buying back their shares. Roche says that at any one time, 20 of the 50 holdings in the portfolio will be buying back shares, a sign that management teams believe their shares are cheap and are committed to supporting the share price.  

The lights may be flashing green, but investors still have little love for this part of the market. It's certainly a far cry from the time when mid-caps were considered the “sweet spot” in the UK market – large enough to be resilient, yet small enough to be dynamic, or when small-caps were a source of reliable long-term outperformance.

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Since the start of this year, large caps have seen a strong rally relative to their international peers, but small- and mid-caps have not kept pace. Year-to-date, the FTSE 100 is up 4.1%, buoyed by a rotation out of mega-caps in the US, which has left capital looking for a new home. However, the FTSE 250 is down -1.7%, while it’s been an even tougher period for small-cap, which is down -3.2%. This reverses tentative signs of a recovery in 2024, when the FTSE 250 delivered a creditable 8.1% return, while the FTSE Small Cap was up 10.7%. Meanwhile, the FTSE 100 adding 5.7% in 2024, or around 9.4% in terms of total return including dividends. 

Interest rate pain to blame

Higher interest rates and general risk aversion have played a role in the weakness for this part of the market.

Kelly Prior, investment director at Marlborough, says: “Smaller companies tend to be seen as suffering more pain from higher interest rates and we’ve had the most aggressive interest rate rising cycle of the past 40 years. We’ve also seen war return to Europe, with Russia’s invasion of Ukraine deepening uncertainty and causing steep increases in energy prices. All this has weighed on the share prices of the UK’s smaller companies.”

There is also the perceived domestic focus of smaller companies at a time when the UK economy has been weak. This view never stood up to a great deal of scrutiny. As Roche points out, over 50% of revenues from UK mid-cap companies are from overseas. Even if it were true, the UK is no longer an outlier in terms of economic weakness.

In reality, the problem has been a dearth of investors. Gavin Haynes, investment consultant at Fairview Investing, says: “UK pension funds have less than 5% in UK equities, compared to 15% a decade ago and the selling of UK stocks from UK institutions and investors has been a drag on UK mid and small companies.”

This may not be getting worse, but it’s not yet getting better. There are government initiatives afoot to encourage UK pension funds to invest more in the domestic market, but this will take time to come through.

Redemptions from UK funds have been relentless, with investors favouring the US, even amid the recent rout. The latest round of Calastone data showed UK investors withdrawing a net £1.19 billion in March, taking the total year-to-date to £3.48 billion, the worst calendar quarter on record for UK-focused funds, and the second-worst of any three-month period.

What might bring investors back to this part of the market? The catalyst may already have happened, says Prior: “With global investors appearing to be increasingly willing to look beyond the US for opportunities, we believe they may be ready to take a fresh look at the highly attractive valuations in the UK market, particularly in smaller companies.”

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Williams agrees that Trump’s trade tariffs are changing the behaviour of governments, customers and corporates. It will dent the profitability of US mega-caps and force a re-think from investors. As investors come out of these high beta mega-caps, history suggests they initially look towards equity income stocks, whose reliable cash flows leave them less vulnerable to setbacks. This has already drawn investors back to UK larger companies.

“As UK large caps outperform, we expect local (UK retail investor) fund redemptions to come to an end, and – ultimately - UK quoted small-caps to have an enormous performance catch-up. There was a similar period after March 2020. That was a glimpse of the scale of the potential. During this period, UK small and micro-caps were about the best-performing asset class globally,” says Williams. 

His view is that allocation flows have already changed modestly, and are about to change wholesale. Roche also points to anecdotal evidence of a change in mood. She says that recent investor conferences have been packed: “That’s telling you that there’s something bubbling under.”

On the right side of the tariff trade?

There are risks in the form of Trump tariffs and UK government tax hikes. On tariffs, UK smaller companies should be on the right side of the trade. Even if they have international revenues, they generally do not have vast and complex supply chains. Their exposure to the US is far less than for their larger-cap peers and they could be beneficiaries of a drive to “buy local”.

Roche says: “UK companies are generally good at tapping into growth outside the UK. Currys (LSE:CURY) has got a big Nordics business. ME Group International (LSE:MEGP) has businesses in Japan, France and Ireland. Nevertheless, there are domestically focused businesses that are doing very well. Dunelm Group (LSE:DNLM), for example, has just announced another special dividend.”

The diversity of the market means that it is possible to swerve US exposure if necessary.  

Both managers are finding plenty of self-sustaining growth opportunities. The Schroders fund has an overweight position in speciality financials. “Not banks, but companies such as CMC Markets (LSE:CMCX), IG Group Holdings (LSE:IGG), Paragon Banking Group (LSE:PAG) and specialty insurers”, says Roche. It also has a significant overweight in consumer discretionary companies.

Williams holds Ondo InsurTech Ordinary Shares (LSE:ONDO), a claim prevention technology specialist that makes something called a LeakBot. This can identify unseen leaks in the water supply. He also holds Yu Group (LSE:YU.), a utility supplier to the corporate sector, where the market capitalisation has grown from £20 million to £645 million in less than five years.

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Haynes says the small- and mid-cap area could offer a good contrarian opportunity. “It’s hard to know what will lead to a turnaround. Traditionally a recovery in the economic cycle is a catalyst for smaller companies to outperform - so investors may need to be patient.”

He likes Artemis UK Smaller Companies for broad UK exposure. “Fund manager Mark Niznik focuses on identifying undervalued businesses in niche markets, looking for companies with innovative products, strong management teams, and the ability to scale operations.”

For a low-cost passive route into this part of the market, Haynes suggests the HSBC FTSE 250 Index fund.  

There’s everything to like about UK small- and mid-cap companies, yet investors remain unconvinced. It’s difficult to know what will change their mind, and many of the potential catalysts – the weakening of US stock markets, a shift in interest rates, stronger earnings and a better outlook for the UK – have already happened. Investors may just need a little time.