UK small caps: good things come in small packages

UK small caps lag market for decade

UK small caps have lagged the wider market by 5%-6% annually since 2010, according to Henderson Smaller Companies Investment Trust portfolio manager Cassie Herlihy.

“something of a lost decade for UK small caps”

External factors drive underperformance

The UK's exit from the EU, pandemic impacts, and inflation from the Russian invasion of Ukraine and Liz Truss mini-Budget have hurt small caps more than larger companies.

Pension funds flee UK equities

British pension funds reduced UK equity investments from 50% to less than 5% of assets over 25 years, causing a 'massive outflow of money' that depressed prices.

Valuations at historically low levels

UK small caps trade at 'exceptionally low' valuations, typically associated with extreme economic stress, despite the underlying economic situation not justifying such depressed levels.

Catalyst needed for recovery

A catalyst such as improved economic conditions or institutional investment flows is needed to boost small caps, as low valuations alone won't guarantee a recovery.

Institutional investment flows returning

Pension providers committed under the Mansion House Accord to invest 10% of workplace pensions in productive assets by 2030, with at least 5% earmarked for UK investments.

M&A boom boosts small caps

Private equity firms and large companies are acquiring small caps at premiums of up to 169% over recent valuations, with £3.9 billion in deals involving FTSE Small Cap constituents this year.

Best small cap investments

The iShares MSCI UK Small Cap UCITS ETF (LSE: CUKS) tracks the MSCI United Kingdom Small-Cap Net index with an average price-to-earnings ratio of 14.5 times and a total expense ratio of 0.53%.

Keller Group: construction growth

Keller Group (LSE: KLR) has market capitalisation of £2.16 billion and sales grew by nearly half between 2020 and 2025, trading at 11.8 times 2027 earnings with a dividend yield of 2.7%.

Sigmaroc: infrastructure opportunities

Sigmaroc (LSE: SRC) mines and refines minerals for construction, with market capitalisation of £1.39 billion and trades at ten times 2027 earnings.

Boku: payment technology growth

Boku (LSE: BOKU) helps technology firms accept local payments, with market capitalisation of £366 billion and trades at less than 18 times expected 2027 earnings.

Small caps: bottom-up approach

Investors should focus on companies with strong cash generation, high margins, low financial leverage, and management teams capable of driving improvement without relying on a strong UK economy.

AI disruption fears exaggerated

Small companies are more agile than larger ones in responding to AI disruption, with many able to quickly adapt and take advantage of changes in the market.

Green shoots of recovery

Small caps have outperformed larger caps over the last six months, with consumer confidence at a two-year high and GDP growth 'not awful' despite not being particularly strong.

Pension funds: potential catalyst

Pension funds may increase UK investments through incentives or regulatory changes, with some already questioning the assumption that the US market will always outperform the UK.

Market recovery outlook

UK small caps are expected to recover as valuations are low, institutional investment flows return, and M&A activity increases, with potential for strong returns in the coming years.