Four myths about UK small caps

Bulls go mad when they see red; carrots help you see better at night; and investing in smaller UK companies means greater risk, less profit and hardly any dividends. And what’s the point? The market is stuffed anyway.

Managing a UK smaller companies fund can be frustrating. Much of my time is spent exploding myths. It is true that I rarely have to explain that bulls are colour blind or that the carrot tale began as wartime propaganda to explain why British pilots with the benefit of radar were finding and shooting down German bombers so accurately.

But many falsehoods about small caps (smaller companies) often go uncorrected, and if repeated enough, get taken to be fact. These include the following:

Small caps are debt-ridden

Let’s start with debt. Many people assume that smaller companies, because they tend to be at a less mature stage than their larger counterparts, have higher levels of debt. This is not necessarily the case.

Just over 6.5% of FTSE 100 (the 100 largest publicly listed companies in the UK) companies (ex-financials) were forecast to have net cash on their balance sheet at the end of April 2025, according to data from FactSet. This compared with about 21.6% for the Deutsche Numis Smaller Companies (ex-financials) index.

The reason is that smaller companies tend to be restricted to borrowing from banks. Larger companies have access to the long-term corporate bond1 market and holding debt is seen as ‘efficient’ as they expect to make a higher return on money they borrow than the coupon (similar to interest) they pay to lenders. 

The numbers challenge perceptions. This gives selective investors plenty of smaller companies to choose from that are not burdened with debt – and a few that are cash-rich. Amongst some of our larger holdings, foreign exchange hedging business Alpha Group has more than £200m on its balance sheet¹, social housing maintenance provider Mears has more than £90m² and risk-and-compliance trainer Wilmington has more than £50m³.

Small caps are unprofitable

Those big numbers underline how profitable many smaller companies are. We are all too familiar with management teams inflating profits by failing to declare costs. It is refreshing to come across the opposite: where businesses materially understate their true profitability. 

Alpha Group, for example, is sitting on more than £2bn of client cash, on which it is currently receiving interest of 4% a year, but this income is excluded from its headline profitability⁴. 

Across the Deutsche Numis Smaller Companies index, less than one out of every 20 businesses is forecast to be loss-making for the year ahead.

Small caps don’t return cash to shareholders

Smaller companies are often assumed to be more likely to reinvest any profits back into the business rather than return it to shareholders.

Yet the forecast dividend yield (the annual income paid to investors on an asset, expressed as a percentage of the asset's price) for the Deutsche Numis Small Companies (ex-ITs) index for 2025 is currently about 3.7% – roughly the same figure as the FTSE 100⁵.

The yield (the annual income paid to investors on an asset) from small caps was lower in the past, when the sector was riding high. This is because yield is expressed as a percentage of the share price, so when one goes up, the other goes down. As a result, the low valuations of today have pushed this metric higher.

But that leads us to another point. Management teams of small caps are currently turning depressed prices to their advantage in another way – the cheaper their company, the bigger the impact of share buybacks⁶ on future profits. I don’t remember a time when more smaller companies have been buying back as many of their own shares⁷.

In the past 18 months Mears has bought back 27 million shares – more than 20% of the total number at the start of 2023 – at a cost of £90m⁸. This has increased profits per share for long-term investors.

But my favourite buyback story is pub chain Fuller’s. Simon Emeny, the company’s chief executive, says the Fuller’s pub portfolio is worth £1bn, but today’s share price acknowledges only about half of that⁹. He could use profits to buy a new pub at full price – or, through share buybacks, he could effectively pick up a pub he already owns and knows for half the price.  

The small-cap market is doomed

Finally, there is the question of the future of the listed small-cap market. In 2024, Peel Hunt published research showing that heightened M&A (merger and acquisition) activity and a lack of IPOs (initial public offerings) had led to a rapid decline in the number of FTSE SmallCap (excluding investment trusts) constituents – from 160 at the end of 2018 to 114 at the end of 2023. If the decline continued at that rate, said the group, the index would cease to exist by 2028.

However, while that number has since fallen to 105 FTSE SmallCap companies (excluding Investment Trusts)¹⁰, when you look at the Deutsche Numis Smaller Companies index and add in those quoted on the AIM market, there are almost a thousand companies to choose from¹¹ – plenty of choice even if you exclude the ‘minnows’.

In the event that the entire listed small-cap market were to disappear, there is no doubt this would be bad for the long-term future of the UK economy. It is something the government and regulator are rightly worried about – but for investors it could be a different story.

From the start of 2019 to the end of 2024, 35 portfolio holdings in our open-ended fund were taken over at an average premium of 48%¹². These were not the sort of excessive offers that had us doing cartwheels in the aisles – often they simply reflected fair value.

I am not alone in saying that there is no shortage of opportunities for small-cap managers to redeploy the funds from these takeovers in other attractively valued companies.

The worst-case scenario of the UK small-cap market becoming extinct would see those funds invested in other companies that themselves would eventually be taken over at similar premiums – and so on until there were no companies left.

In this scenario, I would not need to worry about misconceptions of the UK small-cap market. I would be jobless. But the returns generated getting there should help fund a happy retirement to the garden. I might grow carrots.

Market volatility risk: The value of the trust and any income from it can fall or rise because of movements in stockmarkets, currencies and interest rates, each of which can move irrationally and be affected unpredictably by diverse factors, including political and economic events.

Smaller companies risk: Investing in small companies can involve more risk than investing in larger, more established companies. Shares in smaller companies may not be as easy to sell, which can cause difficulty in valuing those shares.