Three investment options worth exploring: UK small-cap stocks are trading at a 30% price reduction.
Small-Cap UK Equities: Discounted Investments with Potential for Growth
The current market climate may render UK small-cap equity investments seemingly unattractive; however, a closer look reveals a unique opportunity. These stocks are currently trading at a considerable discount, based on data from Morningstar, and a shifting economic environment could propel them forward.
Small-cap UK stocks are estimated to be trading at a 30% discount compared to their fair value by Morningstar's analysts. Despite the company not covering every market sector, it is worth noting that individual stocks within this category might be even more undervalued.
Recent "series of unfortunate events," including Brexit, the Covid-19 pandemic, and high inflation combined with interest rates, have led to this situation.
To entice new investors, subscription deals are being offered for a website magazine that provides the latest financial news and analysis. The magazine features 60% off after the initial trial, and it had 14 consecutive quarters of net outflows as public market investors have shied away from the sector, according to Morningstar. Assets have tumbled to a 10-year low, declining 62% from their post-Covid peak in 2021.
Contrasting these findings, private equity investors have seized the opportunity to secure discounts and have become increasingly active in the UK market. In 2024, one in every 20 UK-listed companies faced a public offer, according to investment bank Peel Hunt.
The bank issued a report at the end of last year, warning nearly a third of companies on London's junior market could be vulnerable to being taken over, with buyers keen to capitalize on discounts in the small-cap space. Joseph Hill, senior investment analyst at investment platform Hargreaves Lansdown, commented that the average takeover in the UK during 2024 occurred at a "whopping 44% premium."
Hill further explained that current undemanding valuations offer an opportunity for investors to include excellent long-term growth potential in their portfolios, as smaller companies are often under-researched, creating numerous opportunities to uncover hidden gems.
When discussing the potential of UK equities, questions arise as to whether this shift in market conditions could signify the lull before a bull run. Firstly, a changing monetary policy backdrop could prove beneficial for the asset class. As small-caps generally struggle during periods of high inflation and interest rates, the slowing of inflation and falling interest rates could create a conducive environment.
Furthermore, events across the Atlantic are starting to challenge the narrative of US exceptionalism. In the first months of 2023, the major European and UK stock market indices have surged ahead of the S&P 500, which has suffered from trade uncertainty. A similar trend is seen in small caps, with the FTSE Small Cap Index up less than 1% this year, while the Russell 2000 is down more than 7% over the same period.
If investors reallocate their assets away from the US, UK companies, regardless of capitalization, may feel the impact. This reallocation could be pivotal, particularly for small caps, given that even minor shifts in institutional flows can have transformative effects in this market.
Analysts argue that the current climate could reset the small-cap effect, which historically has suggested smaller companies outperform over the medium-to-long term. However, investors must bear in mind the higher volatility and risks inherent in the small-cap market.
Three small-cap fund options to consider include the Artemis UK Smaller Companies Fund, the WS Gresham House UK Smaller Companies Fund, and the iShares MSCI UK Small Cap ETF, each offering different strategies and focusing on various sectors.
By capitalizing on the current discounted valuations, investors could be poised to reap the long-term rewards of the UK small-cap market. It is essential to carefully consider each available option to align with investment goals and risk tolerance in this evolving market.
Investors might find the current market downturn, affected by events like Brexit, the Covid-19 pandemic, and high interest rates, an opportune moment to look into UK small-cap stocks, which are estimated to be trading at a 30% discount compared to their fair value. As these stocks are often under-researched, there could be hidden gems that offer excellent long-term growth potential in portfolios, especially as falling interest rates and slowing inflation create a conducive environment for small-cap equities. To make informed decisions, investors should consider various options, such as the Artemis UK Smaller Companies Fund, the WS Gresham House UK Smaller Companies Fund, and the iShares MSCI UK Small Cap ETF, each with different strategies and sector focuses.
