Smaller companies have been out of favour with global investors for several years, but no market has suffered quite as badly as the UK. UK small caps have been trading far cheaper than every other smaller companies market across the globe, with the average 12-month forward price-to-earnings ratio priced 24.3% cheaper than its 10-year average at the beginning of 2025.
This a significant discount versus the next cheapest markets in Europe and Japan, at 19.8% and 8.8% below their 10-year average, respectively.
So why are the UK’s smaller companies so unpopular, even by sector standards? Demand for them is closely linked with the performance of the domestic economy, so when the UK is slow moving, so are small caps, explains Amanda Yeaman, investment director for UK Smaller Companies at Aberdeen.
See also: Trump tariffs loom large over US small caps
“Our market is more domestically focused, so if you are negatively predisposed to the UK, then small caps are the UK on speed,” she says. “That negative dynamic has harshly impacted the smaller companies within that. And when you get those exacerbated flows coming out of the UK, it’s really hard to get good performance.
“The UK has been a less attractive place to invest because of the Brexit implication, and the growth numbers for GDP haven’t been that great versus other geographies. Over the past 10 years, you’ve been better to put your money into the US or China in terms of getting a return.”
Role reversal?
Because investors prefer small caps in fast-growing economies, they have gravitated towards markets such as China and the US. Smaller companies were trading 45.6% and 29% above their average 10-year P/E ratio at the beginning of 2025, while most other small-cap markets endured lacklustre interest from buyers. At the same time, the average small-cap equity worldwide is 3.2% below its 10-year average.
However, the strong economic growth that propelled China and the US appears less vigorous now the two nations are trapped in a trade war. The retaliatory tariffs have heightened inflation forecasts and downgraded growth prospects – particularly in the US, which intends to put taxes on all imports coming into the country.
And this has taken a staggering toll on small-cap valuations. The current 12-month forward P/E ratio for a US smaller company plummeted 26.9% below its 10-year average by May – a far cry from the lofty premiums they traded on at the beginning of the year. China’s small-cap market fell more mildly, with the average stock valued 33.7% above its 10-year average. But amid the tariff turmoil rattling global markets, every other small cap index dropped except the UK.
By May, the average smaller company in the UK was trading 14.5% below its 10-year average, overtaking small-cap markets in the US, Europe and Japan. This sharp rotation means UK small-cap P/E ratios are now more than twice as expensive as the average global peer, which are 33.5% cheaper versus their 10-year average.
Now that global growth is expected to slacken, the UK’s slow and steady economy appears more attractive by comparison, according to Yeaman. And while small caps were hit disproportionately on the downside, they are likely to swing upwards excessively.
“Why does that help small caps? Because they’re more domestically focused,” according to Yeaman. “When people are more positive on the UK, they tend to be more positive on small rather than large caps. We’re hoping a reversal is about to happen where suddenly our ugly small-cap market now looks a lot more attractive.”
This was evident in the soaring rally of UK small caps following US president Donald Trump’s tariff announcements in early April. The FTSE UK Small Cap index is up 9.9% in the two months since, while large caps in the FTSE 100 trail behind at just 1.9%.
Expect delays
Smaller companies have been the clear beneficiary of heightened confidence in the UK economy, but many economists anticipate hurdles ahead. GDP growth beat analysts’ expectations in the first quarter, but those figures were collected before Trump’s tariffs or chancellor Rachel Reeve’s tax changes from the autumn budget came into effect.
The following few quarters may prove to be more dreary than the strong start investors saw at the beginning of the year, but the UK economy doesn’t have to blow the lights out – it just needs to grow consistently, according to Abby Glennie, deputy head of smaller companies at Aberdeen.
“Growth forecasts are not amazing, but they’re OK,” she says. “When you look at periods in the past where we’ve has similar slow but consistent GDP growth, stockmarkets have done quite well in the UK. The risk is that it disappoints on a quarter – which is something that can happen if you have a one-off inflation impact – but we’re on a sustainable path generally.”
In a world where the US economy could hit the brakes, even slow growth is good growth, according to Ken Wotton, managing director of public equity at Gresham House. Investors have drained money from their concentrated US holdings now the States is significantly more volatile, so there’s a lot of money looking for a new home – and the UK could be the prime destination.
Wotton says: “That money has got to go somewhere, and in the short term it has gone to gold fixed-income securities that are low-risk. If and when that starts moving into equities again, it’s likely the allocations to the US will be reduced, and the UK is now looking like a relative safe haven compared with many other places.”
This article originally appeared in the June issue of Portfolio Adviser magazine
