Smaller companies (small caps) have long played a vital role in the UK economy, creating employment and driving investment in diverse national industries and service sectors. Small caps tend to be especially well-suited for delivering innovation, which can be an important accelerant for growth, for both companies and the wider economy. Indeed, this is particularly relevant to the Labour government’s ambitions for directing more capital into UK assets and delivering sustained economic growth. From an investor perspective too, UK small caps have delivered excellent returns over the long term, both on a gross and risk-adjusted basis.

In this context, the relative lack of UK institutional investor exposure to UK small caps from the likes of Defined Benefit (DB) schemes, local government pension schemes or Defined Contribution schemes, has long puzzled me. This is particularly so, when my abrdn colleagues in European and US institutional markets, report no such apparent ‘negative home-bias’ towards small caps from their clients.

Potential reasons for negative home bias

Concrete reasons for the paucity of UK institutional allocation to UK small companies are hard to come by. Although it is worth noting that even before DB pension schemes embarked on their aggressive derisking, small cap allocations were never so material.

A key factor which certainly cannot be ignored is the more recent multi-year period of underperformance of UK equities versus other developed market equities, and especially US equities. Moreover, we have also seen an extended period of large cap outperformance across all global regions. However, the important flipside of this is that UK equity valuations - especially those in the small cap segment, now look very attractive relative to history.

UK on the growth recovery path

In recent months, for my own part, I have certainly seen some signs of reawakening institutional investor interest in UK small caps. Indeed, this is perhaps most evident in the growing number of private equity deals in the space, with some notable buy-outs being seen, and at significant price premiums too. At the same time, the latest Bank of America Global Fund Manager Survey from September revealed a sizeable 10 percentage point jump in institutional investor allocations to UK equities, resulting in the first overweight in the asset class since July 2021.

While valuations, and the enticing prospect of eventual mean reversion are relevant, there are some other factors too, which seem to be aligning quite favourably for UK small caps. Perhaps most notable is the macro environment. A not so well-known fact is that the UK experienced a technical recession in the latter part of 2023. However, in 2024, a strong recovery has now begun, with average (q/q) H1 real GDP growth the strongest in 7 years, barring the post-Covid year of 2021.

Macro conditions supportive for UK small cap earnings

At the same time as recovering growth, thanks to significantly lower inflation, the UK is now in a monetary easing environment, with the Bank of England cutting the base rate by 25bps on 31 July. This was the first rate cut since March 2020, and should be a prelude to significant further easing, with our economists at abrdn expecting a total of 150bps’ worth of cuts in the UK base rate to 3.75% by end-2025. 

An environment of recovering growth and falling interest rates should be helpful for UK small caps, both in terms of debt servicing and demand for products and services. Indeed, in this respect it’s notable that companies in the MSCI UK Small Cap Index are forecast to grow their earnings by 16.4% and 9.9% in 2024 and 2025 respectively, which compares favourably to  forecast earnings growth of 5.9% and 5.7% in 2024 and 2025 respectively for MSCI UK Index.

Source: Bloomberg, data as of 31 August 2024; Note: The MSCI UK Small Cap Index represents 14% of the overall UK equity market, with the remaining 86% in the UK MSCI Index.

Improved political backdrop

Numbers aside, the UK’s current political backdrop matters too. Following a period of instability, there’s a new UK government in place, which this time is also backed by an overwhelming popular mandate. Labour ministers will tell you that the UK should be one of the most politically stable countries in Europe for the next five years. If this proves to be the case, then the climate of improved political certainty should be helpful for UK businesses, and particularly so if combined with the pre-election promise of economic stability. However, beyond this, there also might be a chance that the political side delivers more than expected, should the new government seek to use its mandate for more meaningful market-friendly reforms. 

Putting everything together

For all investors, the combination of attractive valuations, robust earnings growth, coupled with the broader backdrop of recovering growth, monetary easing and improved political conditions, suggests a strong case for UK small cap equities. For UK institutional investors in particular, in addition to zero currency risk, I suspect allocating to UK small caps might actually aid diversification and lessen any tendency towards a negative home bias. 

To conclude, with so many stars aligning, I feel institutional allocators, particularly those looking to up their equity growth exposure, should be giving some consideration to UK small caps.