- Following a challenging few years for small caps, there are early signs that the recovery has begun. Pleasingly, AIM has also participated in this short-term recovery.
- Valuations, while still volatile, appear to have found a floor and present significant reversion potential
- The earnings compounding profile remains strong, and we strongly believe share prices will soon enough reflect value creation (or we will see continued M&A upside).
A challenging period for small cap performance
It’s been a challenging period for small caps, which have materially underperformed large caps in recent years, with the market particularly susceptible to the post-pandemic hangover, the Ukraine war shock and the subsequent rapid rise in inflation and interest rates. The net outflow dynamic from the sector has also been an ongoing headwind.
Recent returns should be viewed in the context of significant long-term outperformance
Historically, small caps have outperformed more often than not over longer time horizons (as shown by the rolling three-year chart below) but with a trade-off that there can be periods of significant underperformance. The magnitude of the recent underperformance relative to large caps, which has been helped by the strong performance of the banks sector, is comparable only to the Russian default/LTCM collapse in the late 90s and the Global Financial Crisis.
While this has been a painful period of small cap underperformance, the historical data shows that previous trough-to-peak recoveries have been significant and rapid.
Rolling three-year returns: small caps vs large caps
Source: FE Analytics, 31.10.93 to 30.06.25, Deutsche Numis Smaller Companies plus AIM (excluding investment companies) gross total excess return vs FTSE 100.
AIM: shorter-term trends are encouraging
AIM has suffered from the same headwinds noted above and the additional inheritance tax uncertainty and changes (reducing the incentive from 40% to 20%) during last year’s Autumn Budget. The market therefore has struggled to stage much of a recovery following the significant drawdown in 2021/2022 but, while still a short period, the year-to-date positive market move does give reason to be optimistic.
Source: FE, Liontrust. As at 24.07.25.
We are also encouraged by an improving trend in liquidity on AIM as the following daily volume chart clearly shows. Anecdotally, we are seeing a broadening increase in buying interest across many of our AIM holdings. We are tentatively optimistic that this represents capital starting to return to the market, attracted by the significant valuation and implied investment return opportunity:
AXX Index daily volume (billion shares)
Source: Liontrust, Bloomberg, as at 28.07.25
Whilst the health of the AIM market continues to be debated, we take confidence from these improving trends and would also note that the recycling of capital from some of the larger AIM stocks which have opted to migrate to the Main Market appears to be adding further support to the market.
UK small caps are a standout area of value
The consequence of the UK being an unloved market and UK small caps being even more unloved is that in the global context, the UK market is currently one of the standout areas of value.
The following analysis shows the valuation of different regional markets relative to the Quest-derived intrinsic discounted cash flow (DCF) valuation. On this basis, the UK is attractively valued and trading at a discount to the DCF-implied valuation (12% upside), whilst the US is trading at a significant premium (40% downside). Within the UK market, smaller companies present the best valuation opportunity with the current upside around 35% if valuations were to revert to the DCF-implied intrinsic value.
The same is true for profit-based valuation metrics, with the current price/earnings and enterprise value/EBITDA (earnings before interest, tax, depreciation and amortisation) of UK small caps of 16x and 6x respectively comparing to much higher multiples for other markets: US (26x and 14x), Europe (16x and 8x), Asia Pacific (16x and 9x).
Upside/downside to intrinsic value
Quest UK Market default valuation vs market capitalisation
Source: Liontrust, Canaccord Genuity Quest, 16.07.25. Intrinsic value = Quest default 40-year discounted cash flow (DCF) valuation for the UK market. UK market level = aggregate capitalisation of all stocks in Quest UK Market universe. LRA: Long Run Average
The table on the bottom right of the slide above shows the current valuation metrics of the UK market and UK small caps compared to their long-run averages (LRA). UK Small is trading at a significant discount across all metrics, with the discounts ranging from 40-60%.
Summary
We are increasingly confident that early signs of a recovery in the small cap sector are starting to emerge, which could herald a reversion in valuations and relative performance against large caps.
KEY RISKS
Past performance does not predict future returns. You may get back less than you originally invested.
We recommend this fund is held long term (minimum period of 5 years). We recommend that you hold this fund as part of a diversified portfolio of investments.
The Funds managed by the Economic Advantage team:
- May invest in smaller companies and may invest a small proportion (less than 10%) in unlisted securities. There may be liquidity constraints in these securities from time to time, i.e. in certain circumstances, a fund may not be able to sell a position for full value or at all in the short term. This may affect performance and could cause a fund to defer or suspend redemptions of its shares. May invest in companies listed on the Alternative Investment Market (AIM) which is primarily for emerging or smaller companies. The rules are less demanding than those of the official List of the London Stock Exchange and therefore companies listed on AIM may carry a greater risk than a company with a full listing.
- May encounter liquidity constraints from time to time. The spread between the price you buy and sell shares will reflect the less liquid nature of the underlying holdings.
- May invest in companies predominantly in a single country which maybe subject to greater political, social and economic risks which could result in greater volatility than investments in more broadly diversified funds.
- Outside of normal conditions, may hold higher levels of cash which may be deposited with several credit counterparties (e.g. international banks). A credit risk arises should one or more of these counterparties be unable to return the deposited cash.
The risks detailed above are reflective of the full range of Funds managed by the Economic Advantage team and not all of the risks listed are applicable to each individual Fund. For the risks associated with an individual Fund, please refer to its Key Investor Information Document (KIID)/PRIIP KID.
The issue of units/shares in Liontrust Funds may be subject to an initial charge, which will have an impact on the realisable value of the investment, particularly in the short term. Investments should always be considered as long term.
DISCLAIMER
This material is issued by Liontrust Investment Partners LLP (2 Savoy Court, London WC2R 0EZ), authorised and regulated in the UK by the Financial Conduct Authority (FRN 518552) to undertake regulated investment business.
It should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Examples of stocks are provided for general information only to demonstrate our investment philosophy. The investment being promoted is for units in a fund, not directly in the underlying assets.
This information and analysis is believed to be accurate at the time of publication, but is subject to change without notice. Whilst care has been taken in compiling the content, no representation or warranty is given, whether express or implied, by Liontrust as to its accuracy or completeness, including for external sources (which may have been used) which have not been verified.
This is a marketing communication. Before making an investment, you should read the relevant Prospectus and the Key Investor Information Document (KIID) and/or PRIIP/KID, which provide full product details including investment charges and risks. These documents can be obtained, free of charge, from www.liontrust.com or direct from Liontrust. If you are not a professional investor please consult a regulated financial adviser regarding the suitability of such an investment for you and your personal circumstances.
