Why UK small caps may be of interest to growth investors

Undervalued and unloved are UK stocks, particularly small-cap stocks

There are many possible growth drivers in spite of these low valuations.

Both domestically and internationally, UK small caps are undervalued compared to their larger counterparts. Their chances of expanding, however, are better than ever.

These growth stocks aren't often among the best choices for do-it-yourself investors due to their smaller size, but this underappreciated industry may be about to recover.

The first is that all UK stocks appear historically cheap. UK stocks have historically traded at a 20 percent discount to their US counterparts in terms of their average price to earnings (PE) ratio, but in recent years, this has widened to over 40 percent, according to Tom Grady, value fund manager at Schroders.

Graph illustrating the average premium/discount of the MSCI UK index from 1974 to 2024 in relation to the MSCI World index.

However, being economical isn't the only factor. Some stocks are inexpensive for a reason, but UK stocks generally don't seem to be like this.

When comparing the US SandP 500's five-year return on equity and five-year revenue growth to the FTSE All-Share index, Grady notes that "most firms in both markets operate within a similar performance range, but some US companies do enjoy exceptional growth and profitability."

Value-driven investors may find that small caps are a great way to ride the wave as UK stocks are expected to recover.

Growth and value for small companies in the UK.

Although UK stocks are generally cheap, small-cap stocks in the nation are especially disliked.

This seems unnecessary. According to Octopus Investments' most recent Growth Barometer Report, small businesses in the UK have better growth prospects than many of their larger counterparts, including the NASDAQ Composite, one of the leading growth stock indices.

In addition to being less expensive given their anticipated earnings, the AIM All Share index is anticipated to beat the Nasdaq in terms of profit growth over the next two years, with the AIM 50the exchange's top 50 stocksfollowing closely behind.

FactSet estimates, July 2025, Octopus Investments.

Even though the UK small caps' profit forecasts have increased, their valuations have decreased despite these better growth prospects.

The chart displays the price of the FTSE AIM 50, the forward PE ratio, and the forecast EPS from June 2021 to June 2025.

Source: Octopus Investments, July 2025, FactSet estimates.

"The share prices of companies listed on AIM have suffered a difficult few years driven by negative fund flows," said Richard Power, head of quoted companies at Octopus Investments. "The remarkable earnings growth that AIM companies have consistently produced has been obscured by this.

Despite the fact that AIM stocks will be subject to inheritance tax (IHT) starting in April 2026, the market is home to a number of businesses that, despite their relatively low valuations, could see significant growth in profitability.

As an illustration, consider Advanced Medical Solutions (LON: AMS). Despite Peel Hunt's prediction that the biotech company's profits will increase by 51% between the fiscal years 2024 and 2027, the stock is only trading at 15 times its 2025 earnings (and about 12 points 5 times its 2027 earnings).

UK small-cap growth is picking up speed.

In recent months, smaller businesses in the UK have begun to pick up steam.

Investment managers Amanda Yeaman and Abby Glennie of the abrdn UK Smaller Companies Growth Trust (LON:AUSC) stated, "We think we are still in the early stages of recovery for smaller companies, with further upside potential."

After the tariffs were announced on April 2, Liberation Day, the UK's large caps had a better start to the year, but this has since changed.

According to Glennie and Yeaman, "we saw a strong rally in small caps, and small caps outperformed large caps in the second quarter" following this pivotal moment. This was caused by the market's greater favoritism of UK domestics, who are more prevalent in UK small caps than in the FTSE100, which is a globally recognized index.

Due to political unrest and worries about possible tax increases in the Autumn Budget, sentiment has been shaky in recent weeks. The price performance declines that have plagued UK small caps in recent years should, in theory, reverse if optimism returns.

"We anticipate that share prices will show improvement once sentiment toward the UK improves, providing investors with the possibility of substantial upside from today's low market levels," Power stated.

It is also important to note that while foreign investors are becoming more optimistic about UK stocks, UK investors are largely responsible for the pessimism surrounding UK business.

According to Schroders' analysis, US investors invested more in UK stocks than any other market in the first five months of 2025.

Glennie and Yeaman state, "We believe that UK-based investors are contributing significantly to the pessimism on UK markets." "There is a lot of data that indicates the UK isn't doing so well, but when you compare it to many other major regions, it's not much worse.

Putting money into UK small caps with strong growth.

While not all brokers permit users to purchase shares listed on AIM, investors can purchase shares of certain UK small-cap companies directly.

As an alternative, they could purchase investment trusts that target smaller businesses in the UK. Data from the Association of Investment Companies as of September 8th shows that investment trusts in this industry currently trade at an average discount of 11.3 percent to their net asset value. The discount offered by AUSC is 9 percent.

Index funds such as the Amundi Prime UK Mid & Small Cap ETF (LON:PRUK), which tracks the Solactive United Kingdom Mid & Small Cap ex Investment Trust Index, are suitable for investors who prefer passive over active exposure. As of 2 September, the top holdings were the materials company Johnson Matthey (LON:JMAT), the banking group Investec (LON:INVP), fund manager Aberdeen (LON:ABDN), and industrial technology company Spectris (LON:SXS).