Time to take stock of UK smaller companies?

Indeed, I recently asked five different investment analysts to pick out three asset classes or sectors which they saw as overlooked or forgotten. They had plenty of suggestions, many of them very different, but small-cap stocks in the UK were a recurring theme – all five analysts picked smaller companies as one of their choices, the only recommendation on which they all agreed.

One argument for UK smaller companies is simply that they’ve been out of favour for far too long. The UK stock market as a whole has underperformed its global peers in recent years and still looks undervalued on metrics such as price to book ratio, despite the much more encouraging returns of the past 18 months or so. But smaller companies in particular have struggled – and not shared fully in the UK’s more recent resurgence.

So much so that the traditional long-term outperformance of smaller companies relative to large-cap stocks has all but disappeared in the UK. If you had put money in these two areas of the market 20 years ago, you’d be sitting on a very similar pot of cash from each one today. That’s highly unusual – smaller companies typically deliver much stronger returns over longer periods.

Is a catalyst for a return to the norm in sight? There could be. In fact, there are several reasons to be optimistic. UK smaller companies are less exposed to major macro uncertainties, such as conflict in the Middle East and the Trump tariffs, for example. They’re often more sensitive to interest rates, which have come down over the past year and now look likely to stay lower, despite inflation fears. There’s also the possibility of M&A activity, with both strategic and private equity acquirers continuing to take advantage of bargain valuations.

None of which offers any guarantee of an immediate recovery for small-cap stocks. But more fundamentally, it’s important to recognise the strengths of many of these companies – from the value of their intellectual property to the quality of their management. Yes, small-cap investing can be risky – but diversified exposure to well-run smaller companies will be rewarding in the long term.

In which case, advisers should take a look at the 20 or so specialist investment trusts offering access to the UK’s small-cap universe. They offer the possibility of investing at a triple markdown – taking advantage of the undervaluation of the UK market versus the rest of the world, the undervaluation of UK small caps versus large caps, and the fact that shares in many small-cap investment trusts still trade on double-digit discounts to the value of their assets.

On this last point, it’s worth saying that discounts have narrowed in the UK Smaller Companies sector in recent months, in line with a fall in investment trust discounts as a whole. Indeed, many smaller companies funds continue to work proactively to bring their discounts down. But good value is still widely available.

Moreover, even leaving the discount point aside, the case for investment trusts as a route into smaller companies is a strong one. This can be an illiquid area of the market, where the closed-ended structure of investment trusts can prove valuable.

It’s an area where specialist management expertise is particularly important, and multiple investment trusts are run by teams with decades of experience. For income-focused investors, meanwhile, the flexibility of investment trusts on how they generate distributions can be useful given that smaller companies may be less likely to pay dividends.

All of which is to say that advisers looking for value right now might want to start their search close to home. Timing the market is a fool’s game – don’t bet on calling the inflexion point exactly – but the long-term prospects for UK smaller companies from where we stand right now look encouraging.