UK equities, particularly in the small-cap segment, are currently seen as undervalued amid a backdrop of economic turbulence and shifting investor sentiments. According to recent analysis from Morningstar, UK small-cap stocks are trading approximately 30% below their fair value. This situation has arisen from a series of events that include the aftermath of Brexit, the COVID-19 pandemic, and prolonged periods of high inflation and interest rates. These factors have contributed to an environment where public market investors have retreated, resulting in historic outflows from the sector. In stark contrast, private equity investors are capitalizing on the opportunity to acquire undervalued assets.
The data from Morningstar reveals that UK small-cap stocks have experienced 14 consecutive quarters of outflows, leading to a decline in assets to a ten-year low, down 62% from their post-COVID peak in 2021. Despite the exodus of retail investors, private equity is increasingly targeting the sector, with reports from investment bank Peel Hunt indicating that one in twenty UK-listed companies received public offers in 2024. The same report cautioned that up to a third of firms on London’s junior market could face takeover bids by 2025, suggesting that the current market conditions might be ripe for acquisitions.
Joseph Hill, a senior investment analyst at Hargreaves Lansdown, pointed out that depressed stock prices have created favorable conditions for takeovers, often at substantial premiums. In 2024, the average acquisition in the UK equity market occurred at an impressive 44% premium. This trend invites a critical question: should retail investors mirror the interests of institutional buyers and reassess their stances on UK equities?
Hill argues that given the current low valuations, retail investors have an opportunity to integrate sound long-term growth prospects into their portfolios. The under-researched nature of smaller companies, he notes, presents numerous chances for investors to identify hidden gems. The historical context of UK equities has been punctuated by challenges stemming from Brexit, which has left the market struggling to regain investor confidence. However, the recent downturn may signal an evolving landscape for small-cap stocks.
Shifts in monetary policy may bolster the appeal of UK small caps. Typically, this sector does not fare well during periods of high inflation and elevated interest rates, which limit their ability to absorb increased costs. With inflation now diminishing significantly from its peak and expectations of declining interest rates on the horizon, the environment might start to favor smaller players in the UK market. Furthermore, global trends are shifting perceptions about US exceptionalism, as European and UK indices have outperformed the S&P 500, which has been weighed down by trade uncertainties.
Managing director at research agency FundCalibre, Darius McDermott, highlights that a significant portion of global equity returns over the past decade has been driven by US companies. However, signs are emerging that institutional investors are reassessing their exposure to the US market. McDermott pointed out that even minor reallocations of global pension money towards UK equities could yield substantial effects, particularly for small caps, which can be significantly impacted by shifts in institutional flows.
Moreover, domestic policy changes may further enhance the landscape for UK small-cap stocks. Under the Mansion House Accord, pension providers have pledged to direct 10% of their default assets toward private markets, with at least half of that allocated to UK investments by 2030. This initiative is expected to channel approximately £25 billion into UK assets. While the policy alone may not resolve the challenges faced by the junior market, it does signal an important move towards revitalizing a crucial segment of the small-cap space.
Recent trade agreements are also seen as potential catalysts for lifting investor sentiment around UK equities. As the market navigates through these multifaceted shifts, it becomes essential for investors to reconsider their approaches, particularly towards small-cap investments.
Meanwhile, both Hargreaves Lansdown and Morningstar identify specific funds that could be worth exploring in the current climate. The Artemis UK Smaller Companies Fund is highlighted for its focus on cash generation and aversion to pre-revenue companies. This cautious strategy may result in slower growth relative to more aggressive counterparts, yet it positions the fund as more resilient in downturns.
Another fund of interest is the WS Gresham House UK Smaller Companies Fund, which has recently been added to Morningstar’s prospects list. This fund adopts a private equity mentality towards investing in UK small and mid-cap stocks, with notable holdings in companies like Everplay, a games label developer, and Moonpig Group, an online greetings card service.
For those preferring passive investment options, the iShares MSCI UK Small Cap ETF stands out as the primary available choice in the category, tracking more than 200 small-cap stocks in the UK with an ongoing charge of 0.58%.
As the landscape continues to shift, the valuation and performance prospects of UK small-cap equities have generated renewed interest among analysts and investors alike, making them a noteworthy consideration for those navigating current market challenges.