UK Small Caps need investor attention - Morningstar
- Mark Watson-Mitchell
- 1 day ago
- 3 min read
29.05.2025
Morningstar today published its report on UK Small Caps and why they require investor attention.
Its analysts estimate that these stocks trade at a significant discount to their fair value, well below historic averages, presenting a potentially attractive entry point.
“UK small caps have been out of favour in recent years, impacted by domestic and global issues like Brexit, Covid-19, and political instability.
Assets are at a 10-year low after surging post-Covid, with more fund closures than launches so far in 2025. UK small caps have been an attractive asset class over the long-term and despite these headwinds, should not be overlooked by investors.
They remain attractively valued on both an absolute and relative basis which has resulted in elevated share buyback and M&A activity.
The inclusion of FTSE AIM shares in the UK’s Mansion House Accord is also a much-needed sentiment boost for a market that remains a fertile hunting ground for patient small-cap investors.
With only one passive fund currently launched, active managers have a 59% success rate over five years versus around 25% for larger caps, highlighting the value of active management in this sector. The vast number of smaller companies creates a broad and often overlooked universe, resulting in an opportunity for active managers to add significant alpha over the long term,” commented Henry Ince, Analyst, Equity Strategies at Morningstar.
Key takeaways:
A Series of Unfortunate Events: Over the past decade, UK small-cap equities have been faced with a series of major headwinds including Brexit uncertainty, covid-19, the 2022 minibudget’s effect on rates, and the inflationary impact of the war in Ukraine.
The UK Remains Unpopular: UK equities have been overshadowed for several years, as US exceptionalism has captivated investors' attention.
UK smaller companies have suffered especially from this trend, enduring a staggering 14 quarters of consecutive outflows.
UK Smaller Companies Are Attractively Valued: UK small caps are among the most undervalued segments of the UK equity market.
Our analysts estimate these stocks trade at a significant discount to their fair value, well below historic averages.
This presents a potentially attractive entry point. Globally, small caps also appear attractively valued, especially compared with US large caps, particularly in the growth sector.
Fund Closures Are on the Rise: Since 2023, significant outflows have pressured the commercial viability of UK small-cap funds.
High-profile asset managers like Baillie Gifford, Aviva, and Ninety-One have exited the category in recent years, leading to the fewest open-end funds since 1997.
This Hasn’t Gone Unnoticed: Corporate and private equity buyers are becoming more active, especially in high-growth sectors.
Acquisition deals have been on the rise since 2020, and private equity firms remain prepared to take advantage of opportunities, with substantial funds available for deployment.
Companies Are Taking Action: UK companies are aggressively buying back shares, signalling strong board confidence.
Buyback activity has reached record levels, especially among large-cap firms. Smaller UK companies are also repurchasing shares with excess cash.
In 2024, buyback activity was strong, and 2025 shows no signs of slowing down.
It’s Not Just About Valuation: Easing monetary conditions could boost small caps, which historically outperform larger caps after rate cuts.
Additionally, a rebalancing of equity allocation could benefit both large and small UK companies.
The Mansion House Accord will funnel £25bn into UK assets, including AIM shares, by 2030, which could provide substantial policy support.
Alpha Potential: The EAA fund UK small-cap equity Morningstar Category had a commendable success ratio of 59.1% over five years, compared with the iShares MSCI UK Small Cap ETF, the only widely available passive fund in the category. In contrast, the success ratios for active UK large-cap and UK mid-cap equity funds were significantly lower at 24% and 25%*, respectively.