Iain Pyle, Manager, Shires Income
At the start of this year, investors were concerned that the arrival of Chinese artificial intelligence (AI) company Deep Seek would derail the long-running bull market in US equities. In the final few months of 2025, the worry is that valuations have moved so far that they underestimate the risks in the global economy. Markets have become dependent on AI as a source of growth, and therefore vulnerable if it does not deliver as expected. Yet there is one market where expectations remain at rock bottom: the UK.
If complacency is a feature of stock markets generally, the UK is still suffering from the opposite problem: low expectations. The recent strong performance of UK larger companies has done little to change this. The FTSE 100, for example, is up 15.3% for the year to date, putting it ahead of the S&P 500 and MSCI World indices.
These low expectations have been particularly evident in the country’s small and mid cap sector. While the UK’s larger, more liquid companies have kept pace with international peers, smaller companies have been vulnerable to worries over the UK economy. The FTSE 250 is only up 7% for the year to date.
These low expectations are not justified by the operational performance of many businesses in the mid cap sector. In general, earnings have been strong. This is opening up an ever-greater gap between perception and reality. Valuations are now even lower than they were 12 months ago. In our view, this is creating real opportunities.
There are clear reasons for caution on the UK economy. The late date for the Budget has created an information vacuum that has been filled with unhelpful speculation about potential tax rises. This appears to have deterred investment and slowed economic growth. The UK’s debt burden remains impossibly large and inflation is far from beaten.
Nevertheless, the UK is not the weakest of its peers. The IMF forecasts it to be the second fastest growing economy in the G7 (after the US) this year, with another 1.3% growth next year. Trade deals, domestic reforms and lower interest rates could also improve growth in the near-term.
Value in small and mid caps?
This is one reason to look at the UK’s small and mid cap sector more closely. The valuation argument is also clear. Not only has this part of the market de-rated, the combination of dividends and share buybacks means that investors are receiving as much as 7% of their investment back each year in distributions alone.
We find many companies in this part of the market that could be ripe for a reappraisal. Hilton Food Group, for example, is a food producer that sells into UK supermarkets. It has a strong track record of growth, but its shares have been hit from a short-term, one-off production issue (relating to inventory and stocking). This created an opportunity to buy a high quality business at what we believe is a lower price.
Greggs is a similar example. As a UK consumer stock, it has been in the firing line for worries over economic growth. In reality, it continues to perform well, with a strong pipeline of new stores. The UK consumer is not nearly as feeble as sentiment around consumer stocks would suggest. Cash savings are still high and real income growth remains positive. People are reluctant to spend and worried about their economic future, but the data is benign. Sentiment is much worse than it should be. In the jobs market, there has been a small drop in people’s propensity to hire, but no large scale redundancies. Companies such as Greggs have been hit excessively hard.
Genuit is a construction supplier. This sounds like an economically-sensitive area, but the company also generates revenues from its water management and drainage operations. It is well run and has a great track record. This has also suffered with short-term weakness, but as with Greggs and Hilton Food, we believe this has created an opportunity.
A recent strategist report from Merrill Lynch suggested investors take a barbell approach to their portfolios, combining US technology with an allocation to the UK market. US technology provides a growth factor but is also where the sell off will hurt most if AI does not transpire as expected. In contrast, the UK should be defensive in the event of market weakness, a combination of low valuation, the sector make-up of the market, and depressed expectations.
Budget catalyst?
The Budget on 26 November may prove a catalyst and could be the point at which the buyers’ strike in the UK’s small and mid cap companies comes to an end. When the overhang of uncertainty is removed, it could be good news. We are really convinced that UK small and mid caps look extremely cheap. Once we get past the Budget, there should be an opportunity to make up some ground.
In the meantime, flows remain weak, but the market has been supported by buybacks, merger and acquisition activity, plus broader risk appetite. A rising tide tends to lift all boats. The sector make-up of the UK has helped lift the larger UK companies – mining stocks, energy and financials. Outside of US technology, markets have generally been value-focused, and the UK is more value-skewed. It has factors working in its favour. People are still looking to reallocate from the US.
In an environment where investors are generally carefree on the risks inherent in the global economy, the UK is an outlier. Investors have tended to focus on the risks rather than the opportunities. The valuation of the market – and of the small and mid cap companies in particular – now looks anomalous. Any clarity that arises from the Budget may be a catalyst for change.
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