It was great this week to talk to three managers who are investing in UK small and medium-sized companies – if you missed it, you can watch the recording back here. Their message seems to be that portfolio companies are trading well, and coping with a macroeconomic environment that has at times been unhelpful, yet sentiment towards the UK and particularly smaller businesses is stuck on negative. The net effect of this is that UK stocks are cheap and, when investors’ confidence returns, the upside could be dramatic. The watchword is patience. Pick a good active manager or two and back them for the long term.

We were really pleased that Patria Private Equity’s Haresh Vazirani participated in the discussion. We were keen to get the perspective of a private equity investor in these businesses. It was great too to get insights from River UK Micro Cap’s George Ensor – generally, it feels as though the smaller end of the UK small companies market is particularly neglected – and from Mark Niznik, who has recently taken on the job of revamping what was Invesco Perpetual UK Smaller Companies and is now Artemis UK Future Leaders.

The de-rating of smaller companies is – as George pointed out – not just a UK phenomenon. The problem has been compounded in recent years by the fixation on US, AI-related, mega cap stocks. Money has been sucked out of smaller stocks and diverted into that handful of names.

The effects of this can be observed in the chart below – taken from our recently published note on Montanaro UK Smaller Companies – Charles Montanaro observed that UK small caps were valued on just 70% of the price/earnings ratio of the MSCI All Countries World Index, the cheapest they had been on this measure over the last 15 years.

That note also highlighted part of the reason for this – 41 months of consecutive outflows from funds invested in UK equities.

Those outflows have caused real problems for managers of open-ended funds, who have often been selling some of their most promising investments to fund redemptions. It is easy to understand the appeal of managing a closed-end fund in such a scenario.

That might be why, despite some consolidation in recent years, there are more trusts focused on UK smaller companies today than there were 10 years ago.

As we discussed, with valuations as cheap as they are, companies are being taken over. The feeling from the listed managers is that – despite sizeable uplifts in share prices on the back of bids, this often happens too cheaply, which is obviously good news if you are the private equity investor on the other side of the deal.

In last week’s Citywire article, I shared my frustration that bids in our sector aren’t really moving the dial for share prices of similar trusts. The same is true in the small cap market. It’s another sign that valuations are irrationally low.

The flip side is that private equity companies are finding it harder to secure exits through IPOs.

The best thing the government could do to help address the situation is to find ways of stimulating the economy and improving the general mood of investors. Other solutions have been proposed including mandating or incentivising more investment in home grown businesses. There is understandable unease about this. Although one idea that I support is to row back the amount that can be sheltered from tax in a cash ISA to create an incentive to favour higher risk/higher reward assets.

Given the length of time that small caps have struggled, it is easy to forget that the long-term picture supports the idea that small caps tend to outperform large caps. We have been through a peculiar period where ultra-low interest rates have distorted everything. At the same time, the US has sucked in capital from across the globe, which has contributed to the success of its economy. Now, for reasons none of us can fathom, Trump seems set on reversing that. The latest idea – section 899 in his Big Beautiful Bill – would allow him to impose tax penalties on foreign investors in US assets. That may trigger a flood of capital into other markets and could be the catalyst we have been waiting for. If it isn’t that, something else will come along – the elastic doesn’t stretch this far forever.