After years of languishing in the wilderness, UK small-cap investing may finally be an attractive proposition for investors. For those willing to look beyond the gloomy economic headlines, a compelling opportunity is emerging in one of the market’s most neglected corners.
I often draw an unusual analogy when describing our investment approach. Like the protagonist of the late-night television show who scours recovery yards for undervalued antiques, we pick through the UK’s small cap universe seeking overlooked gems.
Both require specialist knowledge, patience, and a clear plan for creating value.
Private equity mindset
What investors should be looking for from small cap companies is a private equity-like assessment – which a fundamentally different framework to public market investing.
Investors should not be interested in relative performance or tracking benchmarks. Instead, they should be targeting absolute returns of at least 15% annualised across the cycle on every investment.
This selectivity is striking. Each position must meet rigorous criteria: decent underlying businesses trading below fair value, with significant self-help opportunities and multiple routes to generate returns.
The strategy requires identifying at least four of five value creation levers: organic growth, margin improvement, cash generation, strategic M&A, and rating change.
Investments relying on a single factor are rejected as this is too risky.
Why Now?
Several factors suggest timing may be particularly favourable. First, our portfolio itself is maturing. Multiple holdings are transitioning from recovery situations to growth stocks—moving from perceived C-quality assets to A-quality businesses commanding premium valuations. These transformations represent our most lucrative investment type.
Second, after three years of relentless selling, technical conditions have improved dramatically. Since late May, it has become harder to buy than sell for the first time in years—a clear signal that forced sellers have exhausted themselves. With only a handful of specialist buyers active in recent years, any return of mainstream investor interest could drive significant repricing.
Third, M&A conditions are improving. Trade buyers are regaining confidence, and valuation gaps between public market prices and private transaction values have widened considerably. The recent 110% premium bid for Spectris signals returning corporate appetite for quality assets.
Perhaps most compelling is the valuation anomaly. For the first time this decade, UK small caps have underperformed inflation—a historical aberration for an asset class that has outpaced inflation by 9% annually since 1959. We firmly believe this represents a remarkable buying opportunity.
Beyond UK Exposure
Contrary to assumptions, this isn’t a bet on the UK economy—and frankly, we’re not bullish on it either. Despite being UK-listed, our portfolio derives minimal revenue domestically — just 4% of the portfolio is invested in a company which only derives its sales from the UK – a hospital business. The remaining holdings are highly international, with some generating 98% of revenues outside Britain. This contrasts sharply with typical small cap indices, where 55-60% of revenues come from the UK.
Interestingly, recent tariff concerns may actually benefit our portfolio. Analysis revealed that most holdings pursue local-for-local manufacturing strategies, giving them competitive advantages as global supply chains restructure. Early evidence suggests our companies are already gaining market share.
Current sector exposure reflects our opportunistic approach—we concentrate in TMT, services, healthcare, and specialist industrials where our experience provides analytical edge. Investment themes vary widely, including long-term disruptors growing at around 20% annually with valuations nowhere near reflecting that potential.
The Margin of Safety
Our emphasis on valuation discipline echoes classic value investing principles. Using our Genus genetics investment as an example, we conducted 60 hours of due diligence before investing, consulting leading private equity investors and corporate finance advisers in the genetics sector. This confirmed our entry price offered a 40-50% discount to private market value—a substantial margin of safety even before considering operational improvements.
Crucially, we’re not afraid to admit mistakes. When due diligence on Acuity revealed greater interest income reliance and customer concentration than initially understood, we exited at a loss rather than hope for the best. The capital was redeployed more profitably elsewhere.
Looking Ahead
Current portfolio pricing implies annualized returns around 25%—significantly above our 15% long-term target. We believe we’re entering a period where returns will be significantly higher than the last 15 years.
For long-term committed investors, I believe there’s never a bad time to invest in this part of the market, which generates superior long-term returns. But after years of underperformance, with valuations deeply depressed and multiple positive catalysts emerging, I think now could be a really excellent time. Like those salvaged antiques that emerge from dusty corners, sometimes the best bargains require patience and a discerning eye—and right now, we see them everywhere we look.
By Stuart Widdowson is Co-Portfolio Manager of Odyssean Investment Trust
