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 often go uncorrected, and if repeated enough, get taken to be fact. These include the following:

1. Small caps are debt-ridden

Let’s start with debt. Many 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 5% of FTSE 100 companies (ex-financials) were forecast to have net cash on their balance sheet at the end of August, according to data from FactSet. This compares with about 23% for the Deutsche Numis Smaller Companies (ex-financials) index.

The reason is that smaller companies tend to be restricted to bank debt. Larger companies have access to the long-term corporate bond market and holding debt is seen as ‘efficient’ capital management.

The numbers challenge perceptions. It 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 £150m on its balance sheet, social housing maintenance provider Mears has more than £100m and risk-and-compliance trainer Wilmington has more than £50m.

2. Small caps are unprofitable 

Those big numbers underline how profitable many smaller companies are. Take MONY, the owner of price comparison site moneysupermarket.com. It trades on 10 times earnings and generates a 10% free cashflow yield – which management then has the option of reinvesting in growth or buybacks or distributing as dividends. And it is far from unique.

We are all too familiar with management teams inflating ‘adjusted’ earnings by stripping costs out as ‘non-underlying’. It is refreshing to come across the opposite: where adjusted earnings materially understate the true profitability of a business.

Alpha Group is sitting on more than £2bn of client cash, on which it is currently making 4%, but this income is excluded from its headline earnings. Factor that recurring interest in and you have a company that has grown at more than 20% a year on a 9% free cashflow yield.

Across the Deutsche Numis Smaller Companies index just one out of every 16 businesses is forecast to be loss-making this year.

3. 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 dividend yield for the Deutsche Numis Small Companies (ex-ITs) index for 2025 is 3.2% – not much lower than the 3.8% figure for the FTSE 100.

The yield from smallcaps 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 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 buybacks on future profits. I don’t remember a time when more smaller companies have been buying back their own shares.

In the past 18 months Mears has bought back 17.7 million shares – 16% of the total number at the start of 2023 – at a cost of £53m. This has increased earnings 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 half of that. 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.

4. The small-cap market is doomed

Finally, there is the question of the future of the listed small-cap market. Earlier this year, Peel Hunt published research showing that heightened merger and acquisition activity and a lack of IPOs had led to a rapid decline in the number of FTSE SmallCap constituents – from 160 at the end of 2018 to 114 at the end of 2023. If the decline continues at this rate, said the group, the index will cease to exist by 2028.

However, while there are only 114 FTSE SmallCap companies, when you look at the Deutsche Numis Smaller Companies index and add in those quoted on the AIM market, there are more than a thousand companies to choose from – 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 September 2024, 31 of our portfolio holdings were taken out at an average premium of 48%. 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.