This year has been notably more encouraging for the UK stock market, even if the economic backdrop has remained gloomy.
The FTSE All Share has held its own among global stock markets, keeping pace with the S&P 500 since the start of the year. However, gains have been led by a handful of larger capitalisation stocks, leaving the UK’s smaller companies sector trailing.
UK smaller companies have looked good value for some time, but have struggled against poor sentiment and persistent outflows.
Smaller companies fund managers have been beating the drum for the sector, saying valuations have seldom looked as compelling, but to date, it has largely fallen on deaf ears.
The same arguments that have been made about smaller companies for the past couple of years are still true. If anything, the sector continues to get cheaper
The sector briefly looked as if it was reviving in the first half of 2025, but its strength has petered out.
The same arguments that have been made about smaller companies for the past couple of years are still true. If anything, the sector continues to get cheaper, as corporate earnings improve and there is no commensurate improvement in share prices.
Scott McKenzie, manager on the WS Amati UK Listed Smaller Companies fund, says: “The progress we saw in the UK mid and small-cap indices during spring has stalled somewhat over the quieter summer months, with no signs that the ongoing headwind of UK retail fund selling has dissipated.
“It is clear that we need to see increased money flow into quoted UK companies for sentiment to improve. As always, valuations remain highly attractive and in many cases extreme.”
There has been a discernible rotation into the UK as investors look for alternatives to US assets
The fund flow picture is important. There has been a discernible rotation into the UK as investors look for alternatives to US assets.
Ed Leggett, manager of the Artemis UK Select fund, says: “International investors have been allocating more to the UK. The UK has a more certain political environment and there is a desire to diversify away from the US. We really see that in the share registers.”
However, for the time being, this is confined to the larger companies such as Rolls-Royce or NatWest.
Why now is the time to be brave on UK small caps
The reallocation to Europe has benefited large-cap stocks in the Stoxx 600 index, but also those with exposure to popular themes such as aerospace and defence, or with large data sets that could make them AI winners.
If investors were feeling optimistic, they might say that where large-cap leads, smaller companies could follow. There have been tentative signs of greater interest in mid-caps, which suggests interest is broadening, but it isn’t happening yet.
Part of the problem, as McKenzie says, is that domestic UK investors are yet to be convinced. Outflows remain stubbornly high and that continues to hurt smaller companies’ share prices.
Leggett says: “When we go down the market-cap spectrum, we have to really think about the flow picture and who might buy them from us.”
The ‘broken Britain’ narrative continues to hurt sentiment, and is out of proportion to the UK’s lacklustre but not disastrous economic prospects
Part of the problem is the gloomy story that the UK tells itself about its prospects.
The ‘broken Britain’ narrative continues to hurt sentiment, and is out of proportion to the UK’s lacklustre but not disastrous economic prospects.
At the moment, for example, the upcoming budget is a headwind to sentiment, with the headlines full of ‘difficult choices’, ‘black holes’ and ‘doom loops’.
Legget says: “Because of constraints on raising the four major taxes, think tanks and the press run stories on tax rises, which hits confidence and hits growth. Consumer and corporate confidence are rising, but could be dented by the budget.
“However, once the tax rises are known, confidence should rebound and inflation should start to fall as a result of labour market weakening.”
Paul Marriage, manager on the Premier Miton Tellworth UK Smaller Companies fund, agrees that there will probably be a ‘fudge’ on the budget and sentiment will improve afterwards.
“One suspects we’ll get a couple of months of leaks and media speculation followed by a non-fix that kicks the can far enough down the road to provide some Q4 oxygen. That would be the narrative that might lead us to another respectable, if not blowout, year.”
In the meantime, prices in the UK small-cap market look irrational. Share price movements have been out of proportion to any weakness in the underlying companies.
For example, the real estate sector was hit hard by rising gilt yields, despite it having virtually no exposure to long-term interest rates in its funding structures. In consumer-facing stocks, short-term trading weakness has been punished as if it were structural decline.
These periods of pessimism have usually been a good time to pick up smaller companies
It is impossible to say when this will turn, and there have already been a number of false dawns, but these periods of pessimism have usually been a good time to pick up smaller companies.
Managers report no shortage of opportunities. Marriage says: “With incoming M&A activity continuing at pace, interest in the asset class seems to be picking up and improved sentiment is causing some shares to react strongly to positive news.
“This partly reflects a modest valuation starting point for the asset class which leaves us feeling that there are still a lot of good investment opportunities in our universe.”
McKenzie also highlights takeover activity and ongoing share buybacks across many businesses and sectors as a potential catalyst for sector performance to improve.
Smaller companies have been cheap for some time, and this alone will not bring about a change in the sector’s performance.
However, sentiment may start to improve if there is nothing startling in the budget. With valuations so low, share prices could move fast if investor interest revives.
Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time.
McDermott’s views are his own and do not constitute financial advice.
Darius McDermott is managing director of FundCalibre and Chelsea Financial Services
