The first fund manager I ever met was Andy Brough – then, as now, a mid-cap manager at Schroders.
Some fourteen years later, one thing that sticks with me from that meeting – that UK smaller companies were ‘cheap’. That their shares traded below their long-term average, at a low price compared with their growth potential and below larger firms.
Since 2012 the FTSE Small Cap index has gone on to return 307%*, not up there with the global stock market but considerably more than the 217.1% achieved by the FTSE 100. Although past performance is not a guide to future returns.
In the last two months I’ve met nine UK equity fund managers, and it seems ‘cheap’ UK smaller companies are very much back on the agenda.
This article is for information only and not personal financial advice. Investing can help your money grow, but the value of investments can rise and fall, so you could get back less than you put in. Investing is for the long term, typically 5 years or more.
If you’re not sure investing is right for you, a financial adviser can help.
UK Smaller Company valuations
The FTSE Small Cap index currently trades on an average of 10.6 times earnings*, or a price-to-earnings (P/E) ratio of 10.6x – meaning that on average you pay £10.60 for every pound of today’s profits. That’s not as low as it was back in 2012, but it’s some way below its long-term average and behind the average P/E ratio of the FTSE 100 and FTSE 250 (12.9x and 12.4x respectively). But ratios also shouldn’t be looked at on their own.
You’ll notice that UK smaller companies have been ‘cheap’ for some time now. The P/E ratio of the FTSE Small Cap index has been below its longer run average since late 2021. Fund managers we speak to put this down to UK investors pulling money from the sector and looking overseas.
Our analysis suggests £6.1bn has been withdrawn from UK smaller company funds since 2012. By contrast nearly £8.2bn has been added to funds investing in North American smaller companies in the same period. That steady decline in cash allocated to UK smaller companies will inevitably weigh on valuations.
Speaking to UK fund managers the consensus is that UK smaller companies as a whole will remain in the doldrums until the direction of investment flows change.
The good news is that, with so much money having already left the sector, it may not take a big swing in sentiment to change the trend. Modest inflows or even a decline in outflows could be enough to see valuations start to move upwards. Fund managers have suggested any bounce in valuations could be rapid.
The question is what could trigger such a change of heart among investors?
Catalysts for change?
One option is that while UK stock market investors continue to sit on the sidelines, low UK valuations attract other kinds of buyers. We’re already seeing some evidence of that in the number of UK companies being acquired.
Between the start of 2021 and April 2026, 77 small and medium-sized London listed companies were acquired. The average premium paid over the last five years was 47%. That not only boosts performance of the index, but it also reduces the number of companies remaining money can be invested in – potentially driving up valuations of those remaining companies.
The second option is that the change of Prime Minister we’re expecting any day now results in a period of political stability which the UK has been badly short of in the last ten years. As you have no doubt heard before, companies hate uncertainty – it’s a barrier to investment and so a barrier to growth.
Of course, there have been false dawns before when it comes to UK small and mid-caps.
Whether this time is different remains to be seen, but after such a sustained period of outflows, even a modest reversal in flows could have a big effect on stock prices. This is particularly true in smaller companies, where liquidity (the ease with which companies can be bought and sold) is lower than usual. As a result, if valuations rise, it could be quick and dramatic.
How can you invest?
The good news for investors – there are several ways to invest in UK smaller and mid-sized companies.
You could buy individual companies – though investing in individual companies is riskier because if that company fails, you could lose your whole investment. And investing in smaller companies is even higher risk. If you cannot afford this, investing in a single company might not be right for you.
For more diversified exposure, funds might be a better option. Having said that, investing in these funds also won't be right for everyone, and it’s important you understand the specific risks of a fund before you invest. Make sure your investment fits alongside the rest of your portfolio.
Remember, all investments can fall as well as rise in value, so you could get back less than you invest. For more details on each fund, its charges, and specific risks, see the links to their factsheets and key investor information.
HSBC FTSE 250 Index
Deciding to invest in smaller companies is hardly a passive decision, especially as they’re higher risk. But that doesn’t mean you can’t implement it with a passive option.
The HSBC FTSE 250 Index fund provides broad exposure to UK mid-cap companies. While not the very smallest companies on the UK stock market, these companies are still different to the global giants of the FTSE 100. They tend to be more domestically focussed, generating more of their sales from the UK.
The FTSE 250 currently trades on an average P/E ratio of 12.4x, so higher than the FTSE Small Cap index, but still below its own long-term average of 14.1x. That means it could benefit from a recovery in the valuations of UK smaller companies.
Investors should note that the fund participates in securities lending whereby some of the investments in the fund are lent to others in exchange for a fee. This helps to offset some of the costs of running the fund but adds risk. The fund will also invest in emerging markets through its exposure to investment trusts within the FTSE 250 and emerging markets are higher risk.
Artemis UK Smaller Companies
Given that the argument for investing in higher risk UK smaller companies rests on the idea that they currently offer good value, investors might want to consider a specialist value manager.
Artemis UK Smaller Companies invests in undervalued UK companies with strong free cash flow and robust balance sheets. The team believes this makes its companies more robust, and potentially less exposed to economic cycles. This means they can hold companies through economic cycles, rather than having to rely on a short-term catalyst to boost performance.
The result is a portfolio of 60-90 companies with an average P/E ratio of 9x – some way below the average for UK small companies – and a dividend yield of 4.2%. That yield does at least mean investors are being paid to wait should UK smaller companies fail to re-rate any time soon. Although it is not guaranteed and is not a reliable indicator of future income.
Annual percentage growth
30/06/2021 To 30/06/2022 | 30/06/2022 To 30/06/2023 | 30/06/2023 To 30/06/2024 | 30/06/2024 To 30/06/2025 | 30/06/2025 To 30/06/2026 | |
|---|---|---|---|---|---|
Artemis UK Smaller Companies I Acc GBP | -8.19 | 0.08 | 21.56 | 6.18 | -4.20 |
FTSE 100 TR | 5.76 | 9.15 | 12.79 | 11.30 | 23.64 |
FTSE 250 TR GBP | -14.59 | 1.87 | 13.93 | 10.25 | 10.23 |
FTSE Small Cap TR | -12.56 | 1.20 | 14.55 | 11.15 | 14.33 |
HSBC FTSE 250 Index Fund Class Accumulation S | -15.16 | 2.05 | 14.43 | 9.93 | 10.11 |