The "most unloved stocks in the world" are smaller UK companies Should you invest?

Contrarian investors hoping to claim a valuation discount may find that UK small caps present alluring opportunities

Must you make an investment?

UK stocks have been out of style for almost ten years. As a result of the Brexit referendum in 2016, valuations declined. Since then, the issue has been made worse by sluggish economic growth and a preference for the tech-heavy US market.

Due to private investors' shift away from UK stocks and toward a more international strategy, the domestic market has also suffered. As per the research firm New Financial, only 4 out of 4 percent of UK pension assets are currently invested in domestic stocks. This is the lowest point ever. The average world-wide is 10.1%.

The bright side of this specific cloud is that it has resulted in valuation discounts for investors looking for a deal. Potentially, those who have the patience to wait for a rerating could benefit greatly.

Global investment firm Abrdn's research indicates that smaller UK businesses present unique opportunities because they are trading at a discount of over 24% to their 10-year average. Of all the regions, this one offers the largest discount.

A recent period of high inflation and interest rates has hurt small-cap valuations. In addition to being more leveraged (and therefore more vulnerable to floating-rate debt) than their larger counterparts, small businesses may find it harder to accept price increases.

When sector-specific and regional factors collide, the UK small cap market has experienced a double discount.

According to Abrdn, smaller companies around the world are trading at a 3point 2 percent discount, but among UK small caps, this gap widens considerably to 24point 3 percent. This is the case even though recent Factset data predicts that UK small caps will increase their earnings by 10% over the course of the upcoming year.

The UK small cap manager at Abrdn, Abby Glennie, stated, "These discounts reflect the negative sentiment that we've seen towards UK smaller companies in recent times."

"It's true that the industry has had a difficult time, with worse performance and stricter regulations. Negative sentiment, however, is ultimately just thata sentiment. According to the fundamentals, there are a lot of outstanding smaller businesses in the UK that are outperforming their larger and international competitors in terms of earnings growth," she continued.

Which geographical areas have the largest stock market discounts?

The table below illustrates whether stock markets appear inexpensive now in relation to their historical average. Price-to-earnings (P/E) ratios that look ahead are the basis for the evaluation. P/E ratios indicate how much you must pay now in order to be exposed to future profits. The 10-year average and current P/E ratios are compared to determine the discount (or premium) figures.

Source: ABC through Abrdn. Everything up until January 31, 2025.

Will small-cap valuations in the UK catch up?

Finding an undervalued stock market is all well and good, but a catalyst is required for markets to catch up if investors are to profit. For many years, UK equity enthusiasts have been discussing how undervalued the industry is. It would be reasonable for investors to wonder why this time should be any different.

For the previously mentioned reasons, the declining interest rates may be good news for small-cap firms. Investors are also beginning to see that the UK might provide a haven of stability in a world that is becoming more and more unstable.

Jason Hollands, managing director at investment platform Bestinvest, stated that Prime Minister Keir Starmers' meeting with President Trump last week went exceptionally well, with the President hinting at the possibility of a speedy trade agreement that could spare the UK from the impending trade war between the US and EU.

"A trade deal could force the UK to make stark choices about whether it should remain aligned with the EU, and investors should be a little cautious about reading too much into this," he added. "On the surface, this should be seen as encouraging news that might also help restore some optimism in UK equities."

For those evaluating the case for smaller businesses in the UK, there are still substantial risks. Since large cap stocks get a large amount of their profits from overseas, small caps are more vulnerable to the domestic economy. Changes such as the April increase in employers' National Insurance contributions may therefore have a more direct impact on them if the policy impedes UK economic growth, as many have predicted.

According to the British Retail Consortium's recent survey of 52 major retailers, 56% of businesses are thinking about cutting back on overtime or employee hours in response to the National Insurance policy. Approximately 50% are thinking about cutting back on staff. In the UK economy, all of this could result in lower disposable income and, consequently, lower spending.

Future modifications to inheritance tax laws may also have a negative impact on small caps in the UK. Currently, shares traded on the alternative investment market (AIM) are exempt from inheritance tax; however, starting in April 2026, this exemption will be lowered from 100% to 50%. The alterations have "put a dent in the optimism of many investors hopeful for a rekindling of this very dynamic market," according to Evangelos Assimakos, investment director at Rathbones Investment Management.