In the current investment landscape, where sentiment towards UK equities remains subdued, UK small-cap companies represent a compelling and often overlooked opportunity for discerning investors.
The perception that British companies are cheap is well-founded, with UK firms trading at an average of about 12.6x their profits, significantly lower than the 24.2x seen in the US.
It would be fair to say that UK shares, particularly those in smaller companies, remain unloved. Because of this, many companies are seen as targets for overseas takeover.
Over the past few years, there has been an increase in focus on Silicon Valley's tech giants, which adds to the many hugely innovative British businesses in the technology sector being overlooked.
Many have viewed the UK market with apprehension, which led to a net outflow of £9.6bn from UK funds in 2024. This has created a fertile ground for bargain hunting in which shrewd investors could see this as a moment to recognise that Britain is a bargain bet.
Common misconception
There is a common misconception that by investing in UK small-cap companies you are simply putting all your chips on the UK economy and markets.
However, despite these being small companies and listed in the UK, they have significant global exposure, which allows for diversification against the prevailing doom and gloom narrative of the UK domestic market.
There are several characteristics within UK small-cap companies, particularly those that are too small to be listed on the FTSE250, that highlight the ‘hidden gems’ of the sector.
These characteristics indicate strong growth potential that keen-eyed investors might be able to spot:
- Unique intellectual property (IP) and global niche leadership: The most attractive smaller companies often utilise their own intellectual property in their products or production processes. This allows them to become global leaders within specific niche markets. Such specialised expertise is difficult to replicate, providing a significant economic moat that underpins long-term investment value.
- Exposure to megatrends: While industrial companies, for instance, can be cyclical, many smaller businesses enjoy exposure to long-term growth megatrends. These can include increasing artificial intelligence (AI) spending, global investment in renewables, or growing demand for healthcare solutions. These overarching trends can offer substantial opportunities for patient investors, even when short-term market fluctuations might obscure their underlying growth stories.
- High-quality, experienced management: Smaller businesses, particularly in complex industrial sectors, require adept management to navigate production, research and development (R&D), and evolving market demands. Therefore, backing proven and experienced management teams who can add significant value is crucial for success.
These characteristics highlight the potential for significant re-rating in these overlooked businesses, whose shares currently trade at low Enterprise Value/Sales multiples compared with their long-term history.
The current market environment, characterised by improving sentiment and potential for increased merger and acquisition activity, suggests that the tight liquidity that once held back share prices could now work in reverse as uncertainty clears.
Medium-term optimism
UK smaller companies continue to be significantly undervalued in both absolute and relative terms. An improvement in investor sentiment could rapidly reverse the fortunes of these shares. In the absence of such a shift, their inherent value makes them attractive targets for overseas takeover approaches, which could increase.
The combination of fundamental quality, growth catalysts, and prevailing undervaluation positions UK small-cap companies as compelling opportunities for investors looking to capitalise on these hidden gems as market sentiment gradually improves.
Global reach
Many UK businesses, even smaller ones, are far from being solely local players; they are often industry leaders with substantial global exposure.
For instance, while FTSE 100 companies derive around 74% of their revenues from overseas, and FTSE 250 companies generate approximately 51% of their sales internationally. The perception is that smaller companies are a play on the domestic economy. However, outside of the consumer sector, many smaller companies in the TMT, healthcare and industrial sectors generate significant portion of their revenues from outside of the UK, diversifying their economic and political risk.
This global reach means that many of these internationally focused smaller companies are undervalued compared to their international peers. Whilst we hope they will re-rate to their fair value, in the absence of this they appear to be sitting ducks for overseas corporate acquirers.
Stuart Widdowson is portfolio manager of Odyssean Investment Trust. The views expressed above should not be taken as investment advice.