In this article, we bring you three key reasons to consider investing in the UK smaller companies subset, despite recent market turbulence.

Attractive valuations

Due to their potential for long-term returns and growth, listed smaller companies typically trade at a premium valuation, because investors are willing to pay more for access to this potential. However, their premium is currently far below historic averages.

This suggests that investors may get much better value if they buy into UK smaller companies now than they would typically have done by investing in them over the past 10 years.

Comparing the MSCI UK Small Cap Index with the MSCI UK Index (which covers large and mid-caps), we found that the former is trading at a 13% premium valuation, using a 12-month forward price-to-earnings ratio to the end of October (1).

This is significantly below the 37% average premium UK smaller companies have traded at over the past 10 years (1).

 Figure 1: Small cap equity valuations

Source: Bloomberg, 31 October 2024. For illustrative purposes only. No assumptions regarding future performance should be made. 

Looking across the MSCI small cap indices globally, almost all of them have valuations currently below their historic averages. The UK ties with Europe as the region where valuations are lowest compared with their historic average and therefore the two are the ‘cheapest’ regions in absolute terms. 

US small caps have had a good run recently following the re-election of Donald Trump as US president, but this means they are trading at a 70% premium valuation to their UK peers (1). 

UK small caps was one of the leading indices this year - until the US election. Nevertheless, we’ve seen a respectable showing by UK small caps in the year to date. 

Earnings growth potential

All this is supported by strong prospective earnings growth for UK smaller companies. 

Companies in the MSCI UK Small Cap Index are forecast to grow their earnings by 25.6% and 17.4% in 2024 and 2025 respectively. While the large and mid-caps that make up the MSCI UK Index are forecast to grow earnings by much less: 2.2% and 4.6% over the same time-frames (1).

Source: Bloomberg to 31st October. For illustrative purposes only. No assumptions regarding future performance should be made.

A possible interest rate boon

What’s more, separate data shows that UK small caps have historically outperformed the FTSE 100 following interest rate cuts. While this isn’t guaranteed by any stretch, it suggests that the UK’s current interest rate-cutting cycle could be a potential boon for this segment of the market.

Research by Berenberg, looking at the performance of UK small, mid and large-cap stocks following UK rate cuts going back to the 1970s, shows that historically this environment has been positive for smaller companies (2).

In the 12 months after an interest rate cut, the valuations of UK smaller companies grew by 9.3% on average, according to Berenberg. This compared with just 6.5% for the FTSE 100. Our economists are expecting the UK base rate to fall to 3.75% by the end of 2025.

Don’t miss out

UK smaller companies have been overlooked by many investors, particularly domestic institutional investors in recent years. This is partly because portfolios have been reweighted to become more global, leaving little room for UK smaller companies.

Arguably, investors are missing out on a significant potential opportunity by not considering this area of the stock market. UK smaller companies currently offer attractive value and robust earnings growth which, coupled with the broader backdrop of recovering growth, monetary easing and improved political conditions, make for a compelling proposition.

Final thoughts

Smaller companies offer diversification benefits when included in a broader portfolio. Holding for longer periods, such as five years, can help investors navigate volatility and target attractive returns. We see a particularly compelling entry point into UK smaller companies at the moment, given current valuations. Meanwhile, strong company balance sheets and reporting on the part of our investee companies provide further encouragement.