Could overseas investors jump the queue on a small-cap recovery?

Britons remain famous for their love of queuing, instinctively adhering to the unwritten rule that they form an orderly line when more than one person is waiting for the same thing.

This little ritual helps to preserve a sense of fairness, speeds up the provision of services and avoids the unpleasant scenario of a free-for-all. Yet there are times when sticking rigidly to this social convention can be counterproductive – and I’m not just talking about the post-pandemic phenomenon of queuing at the bar. 

When your turn has come but your mind is elsewhere and you ignore the less-than-subtle hints from those standing behind you, can you really blame them if they just… push in? 

Outflows

As I write this, news has broken that UK investors pulled a net £9.5bn from domestic equities last year¹. I suppose you could argue that this hardly constitutes ‘news’ – they pulled a similar amount of money from UK equities in 2024 and the asset class has now seen net outflows in every year since 2016. 

What does make the statistic interesting is it came in a year when the FTSE All-Share returned 24% – more than twice as much as the S&P 500. Us Britons may not be buying UK shares, but someone is. 

UK Smaller Companies sector net fund flows (£m)

Past performance is not a guide to the future.

Source: Investment Association up until 31 October 2025. November/December data for 2025 are Morningstar Direct estimates.

*Bloomberg, class I accumulation units in GBP from 1 January 2015 to 31 December 2025. All figures show total returns with dividends and/or income reinvested, net of all charges. Performance does not take account of any costs incurred when investors buy or sell the fund. This class may have charges or a hedging approach different from those in the IA sector benchmark.

Even after such a strong run, the P/E ratio of the UK market sits well below the global average (this remains true even if you remove the US). But there is a sector that sits on a further 20% discount² to the large caps that drove the FTSE All-Share’s performance last year – UK small caps. 

Talking down the UK

It’s sometimes difficult to put into words just how unpopular this sector is. The small-cap market derives about 60% of revenues from the domestic economy (compared with just 20% for large caps)³, which over the last decade has been hit by Brexit, Covid and higher interest rates. And don’t we know it: in any year without a World Cup, it is not queuing but bashing the UK that becomes our national pastime. 

Despite all the negativity and market shocks of the past decade, our Artemis UK Smaller Companies Fund still managed to double investors’ money. There is no real secret here: we invest in undervalued companies that have strong balance sheets and are generating healthy levels of free cashflow. 

Flows into UK Equity from Foreign and Domestic Mutual fund Investors - weekly flows, USD (bn)

Source: EPFR, Goldman Sachs Global Investment Research

When the market gets cheaper – and it has seen net outflows in nine of the past 10 years – takeovers and share buybacks become more prevalent. These will continue to drive returns if the sector sees similar headwinds over the next decade as the last.

Headwinds to tailwinds

But here’s the thing. Not only do we think we are unlikely to see similar headwinds over the next decade, we believe many of them are now turning into tailwinds. The government is working towards greater integration with the EU. Interest rates are falling rather than rising. And it is becoming harder to see where the marginal seller will come from.

In any year without a World Cup, it is not queuing but bashing the UK that becomes our national pastime

This last point is perhaps the most important one. The reason why the 20% discount to large caps is so interesting is that small caps have traditionally traded at a premium. And with good reason – they have delivered much higher returns over the long term. 

The UK economy is stronger than you think

Based on the overwhelming narrative of negativity around the UK, it would be entirely rational to expect this discount to persist. However, this pessimism is at odds with what we are seeing at the company level. Pub chain Fuller’s recently reported first-half earnings per share up 37%; package holiday operator On The Beach reported first-half earnings per share up 14%; and sofa retailer DFS reported full-year profit before tax up 188%. 

These are not supposed to be representative, but they should serve as a reminder that, even for businesses exposed to discretionary consumer purchases, things are better than widely perceived. 

The reason why the 20% discount to large caps is so interesting is that small caps have traditionally traded at a premium. And with good reason – they have delivered much higher returns over the long term

And rather than getting worse, we think they could get better still. If, as expected, there is no spike in unemployment, confidence should improve and consumer spending (which makes up 60% of the economy) would recover. The money is there – the savings ratio currently stands at 9.5%⁴, close to twice its pre-Covid level. It is estimated that a single percentage point fall in this figure would provide a £17bn boost to the economy.

Creating a ‘growth loop’

What happens if this finally convinces investors to return to UK small caps? Well, we could see a virtuous circle or ‘growth loop’. Increased investment. Faster growth. Rising confidence. Further fund inflows. 

How does this work? Fund inflows reduce companies’ cost of capital as their share prices rise.  A lower cost of capital reduces the required-rate-of-return hurdle that companies must exceed to justify investment. Higher investment boosts productivity and UK growth. Critically, investors who are early would also be handsomely rewarded through strong equity returns as share prices re-rate upwards.

Such a trend could finally help dispel the negativity around the UK. And remember, there’s a World Cup this year! But could it convince UK investors to start buying UK smaller companies once again? We’re not sure it matters – there is no polite queuing system here. If they don’t, then someone else will.