Since UK small caps are trading at a 30% discount, there are three funds to take into consideration

UK small stocks haven't been popular for a while, but a changing economic climate might help them

Although they aren't a trendy investment, UK stocks could be a wise choice. According to Morningstar data, small-cap stocks in particular are trading at a substantial discount, and a changing economic landscape may help them.

According to the research firm's analysts, UK small companies are trading 30% below their fair value. The fact that the company does not cover all market segments highlights the possibility that individual stocks may be even more cheap.

A "series of unfortunate events"such as Brexit, COVID-19, and a period of high interest rates and inflationhave led to this predicament.

Due to fear, public market investors have withdrew their funds from the industry; Morningstar has recorded 14 quarters in a row of outflows. Assets are down 62% from their post-Covid peak in 2021 and have fallen to a 10-year low.

However, private equity investors have seized the chance to get a deal in bargain Britain and are not shunning them. According to investment firm Peel Hunt, one in twenty of all UK-listed companies went public in 2024.

As buyers seek to take advantage of discounts in the small cap space, the bank warned in a report released at the end of last year that up to a third of companies on London's junior market may be at risk of a takeover in 2025.

Joseph Hill, senior investment analyst at investment platform Hargreaves Lansdown, stated, "Reduced stock prices create a ripe environment for takeovers, and we've seen these coming at significant premiums on average."

"Whopping 44 percent premium" is the average takeover price in the UK equity market in 2024, he says. Thus, the question arises: should institutional buyers lead retail investors to become more optimistic about the UK?

Hill continued, "Investors have the chance to enhance their portfolios with exceptional long-term growth potential at the current low valuations." There are many opportunities to find hidden gems because smaller businesses are typically under-researched as well.

Is this a different time for UK stocks?

Brexit has made UK stocks unpopular, but the market hasn't recovered yet. There will be some investors who are impatient with valuation. Is playing with small caps a good strategy, and why should this time be any different?

First, a changing environment in monetary policy may be advantageous for the asset class.

Because they can't absorb higher costs as well as their large-cap counterparts, small-cap stocks typically suffer during times of high inflation and interest rates.

This, along with regional issues, has resulted in a double-discount for small caps in the UK. Interest rates are currently declining, though, and inflation has now significantly decreased from its peak.

Events in other countries are also casting doubt on the idea that the US is exceptional. The SandP 500, which has been negatively impacted by trade uncertainty, is far behind the major European and UK stock market indices so far this year.

There is a comparable pattern in small caps. While the Russell 2000, a US small-cap index, has lost more than 7% of its value over the same time period, the FTSE Small Cap Index has gained less than 1% so far this year.

UK businesses of all sizes may be impacted if investors begin to shift their investments away from the US.

US companies accounted for 19 out of the top 20 contributors to global equity returns over the last ten years, according to Darius McDermott, managing director at research firm FundCalibre. Over the previous two years, the Magnificent Seven alone were responsible for half of MSCI World's gains. This power is currently in jeopardy.

Pension funds are increasingly reevaluating their exposure to the US, which suggests that a global market meltdown may be imminent. People always undervalue the power of technical flows, but few will leave the US completely or should," McDermott stated.

"Reallocating even a small portion of global pension funds to listed UK stocks could have a noticeable effect, particularly for UK small caps, where even slight changes in institutional flows have the power to revolutionize the market.

The UK small cap environment may also be improved by domestic factors. Workplace pension providers agreed to invest 10% of their default funds in private markets by 2030, with at least half of that amount going to the UK, as part of the Mansion House Accord.

They include UK shares listed on the Alternative Investment Market (AIM), even though they are public-market assets. The government estimates that this will invest a total of 25 billion in UK assets.

The junior market has experienced takeover activity, a dearth of IPOs, and tax changes in recent years, so the policy alone is unlikely to improve the situation. It does, however, update a significant segment of the small cap universe with some much-needed positive news.

Regarding UK stocks, recent trade agreements may also improve investor sentiment.

Consider these three UK small-cap funds.

The Artemis UK Smaller Companies Fund is mentioned by both Morningstar and Hargreaves Lansdown as one that might be worthwhile to look into.

Because they place a high priority on cash generation, the managers will not invest in businesses that are already profitable. "They are also wary of investing in small businesses with extremely high growth expectations," says Hill.

Because of this, in a rising market, the fund might underperform its growth-oriented peers, but in a falling market, it might be more resilient.

Morningstar recently added the WS Gresham House UK Smaller Companies Fund to its list of potential investments, and it might be worth a look.

The fund uses "a private equity mentality to invest in UK small caps and mid caps," according to Morningstar. Moonpig Group and Everplay, a developer of game labels, are among the top ten holdings.

The performance of both funds has been in the top quartile for one, three, and five years.

Consider the iShares MSCI UK Small Cap ETF if you'd rather have passive exposure. Small-cap ETFs in the UK are scarce, so if you're looking for a passive fund, this is your only viable option.

It has an annual fee of 0.58 percent and tracks more than 200 small-cap companies in the UK.