UK equities have been unfashionable for the best part of a decade. Valuations suffered as a result of the Brexit referendum in 2016. Since then, limp economic growth and a preference for the tech-heavy US market have compounded the problem.
The domestic market has also suffered as private investors have diversified away from UK equities to adopt a more global approach. Just 4.4% of UK pension assets are now held in domestic equities, according to think tank New Financial. This is a historic low. The global average is 10.1%.
The silver lining of this particular cloud is that it has created valuation discounts for bargain-hunting investors. Those who are patient enough to wait for a rerating could potentially reap meaningful rewards.
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Research from global investment company Abrdn suggests UK smaller companies offer particular opportunities, trading at a discount of more than 24% compared to their 10-year average. This is the widest discount of any region.
Small cap valuations have suffered in recent years thanks to a period of high inflation and interest rates. It can be more difficult for small companies to swallow price increases, and they are often more leveraged (and more exposed to floating-rate debt) than their larger counterparts.
This has created a double discount in the UK small cap market, with regional and sector-specific factors colliding.
Smaller companies globally are trading at a 3.2% discount, according to Abrdn, but this widens significantly to 24.3% among UK small caps. This is despite the fact that UK small caps are forecast to grow their earnings by 10% over the next year, according to recent Factset data.
“These discounts reflect the negative sentiment that we’ve seen towards UK smaller companies in recent times,” said Abby Glennie, UK small cap manager at Abrdn.
“True it’s been a tough period for the sector – with weaker performance and tightening regulation. But ultimately negative sentiment is just that – sentiment. When you look at the fundamentals, there are many brilliant smaller companies in the UK who are outperforming global and much larger rivals in terms of earnings growth,” she added.
Which regions offer the biggest stock market discounts?
The below table shows whether stock markets look cheap today compared to their longer-term history. The assessment is based on forward-looking price-to-earnings (P/E) ratios. P/E ratios tell you how much you need to pay up front today to get exposure to future earnings. The discount (or premium) figures are arrived at by comparing today’s P/E ratios with the 10-year average.
|
MSCI Index |
Large caps: current 12-month forward P/E ratio vs 10-year average |
Small caps: current 12-month forward P/E ratio vs 10-year average |
|
All Country World Index (ACWI) |
20% |
-3.2% |
|
Asia Pacific ex. Japan |
3.7% |
21.1% |
|
China |
-11.5% |
45.6% |
|
Emerging Markets |
5% |
14.7% |
|
Europe |
0.1% |
-19.8% |
|
India |
8.9% |
-0.8% |
|
Japan |
-2.4% |
-8.8% |
|
UK |
-7.7% |
-24.3% |
|
US |
29% |
29% |
Source: Bloomberg via Abrdn. All data up to 31 January 2025.
Will UK small cap valuations catch up?
It is all well and good identifying a stock market as undervalued but, for investors to benefit, there needs to be a catalyst for markets to catch up. UK equity enthusiasts have been talking about the sector being undervalued for years. Investors would be sensible to question why now should be any different.
Interest rates are on a downward path, which could spell good news for small cap companies for the reasons introduced previously. There is also a growing sense among investors that the UK could offer a place of stability in an increasingly volatile world.
“Prime Minister Keir Starmer’s meeting with President Trump [last week] went remarkably well, with the President dangling the prospect of a quick trade deal that could see the UK avoid the looming trade war between the US and EU,” said Jason Hollands, managing director at investment platform Bestinvest.
“Investors should remain a little cautious about reading too much into this, as the President’s views can soon chop and change and a trade deal could force the UK to make stark choices about whether it should remain aligned with the EU, but on the surface, this should be seen as encouraging news that might also help restore some optimism in UK equities,” he added.
That said, significant risks remain for those weighing up the case for UK smaller companies. Small caps are more exposed to the domestic economy than large cap stocks, which derive a significant portion of their earnings from overseas. As a result, changes like the increase to employers’ National Insurance contributions from April could affect them more keenly, if the policy creates a stumbling block for UK economic growth, as many have forecast.
A recent survey of 52 leading retailers, conducted by the British Retail Consortium, suggested that 56% of companies are considering reducing employees’ hours or overtime in response to the National Insurance policy. Around half are considering a headcount reduction. All of this could translate into less disposable income and therefore less spending in the UK economy.
UK small caps could also take a hit as a result of upcoming changes to inheritance tax rules. Shares traded on the alternative investment market (AIM) are currently exempt from inheritance tax, but this relief will be reduced from 100% to 50% from April 2026. Evangelos Assimakos, investment director at Rathbones Investment Management, said the changes have “put a dent in the optimism of many investors hopeful for a rekindling of this very dynamic market”.
