UK small and mid-caps often present intriguing investment opportunities. Despite their recent challenges, these segments remain compelling for long-term investors who focus on total return. At the VT Downing Small & Mid-Cap Income Fund (DSMI), our process is designed to identify companies with resilient financials, robust shareholder returns, and the ability to unlock value through strategic reinvestment to drive earnings growth, growing dividends.
The UK market in context
Over the past two decades, UK small-caps have consistently outperformed their large-cap counterparts. Notably, the prolonged dominance of US large-caps stands as an outlier, while the rest of the developed markets, particularly the UK, showcase the value of small-cap investing. However, recent sentiment-driven underperformance has cast doubt on the mid-cap space, with the FTSE 250 seeing 62% of its returns eroded by multiple compression since 2014. This has created an exciting valuation opportunity, as the FTSE 250 now trades at a steep discount to its 10-year average, offering what we believe to be significant upside potential.
Valuation meets growth potential
As of January 2025, the FTSE 250 is trading at over a 24% discount. At the same time, consensus forecasts point to this index offering the highest earnings growth and upgrade momentum compared to other major indexes, with north of 20% earnings growth for 2025 and which have been upgraded by 51% over 2024. For discerning investors, this creates a unique combination of valuation re-rating potential and robust fundamentals.
Our focus is on businesses with durable cash generation, sustainable competitive advantages, and disciplined capital allocation. Importantly, we look for companies capable of delivering total annual returns of 10% or more through a mix of earnings growth and dividends.
Themes driving returns
- Structural resilience We target companies that exhibit financial strength and stable or improving margins. XPS Pensions Group, for instance, is a core holding that has exceeded our 10% annual return target. The company delivers actuarial and investment consultancy services and has shown consistent earnings and dividend growth, supported by an 87% increase in earnings per share (EPS) and a 59% rise in ordinary dividends over the past three years.
- Valuation recovery Leading UK construction group Galliford Try, another portfolio company, highlights the opportunities arising from valuation anomalies. At entry this company was trading at a discount to the cash it held on the balance sheet. Management have delivered a growing orderbook and improved operational performance in a structural supported marketplace which has allowed the company return 40% of our initial investment through dividends and buybacks. Galliford Try’s 92% order book visibility and 10% forecasted compound annual growth rate (CAGR) of earnings over the next three years provide additional confidence in its ability to create long-term value.
- Quality compounding We are equally focused on companies with scalable business models. Independent publishing house Bloomsbury Publishing exemplifies this, with its “flywheel effect” of reinvestment into high-quality content driving international earnings growth. Over the last 6 years, Bloomsbury’s EPS has grown at a CAGR of 13.6%, while dividends per share (DPS) has risen by 8.3% annually. Such quality compounders are rare and provide a backbone of stability and growth to our portfolio.
What’s next for UK small & mid-caps?
Investor sentiment toward UK equities is starting to improve, as global funds now hold record overweight positions in the region. Yet, the FTSE 250 remains attractively priced compared to its historical valuation levels. This disconnect presents an opportunity for forward-looking investors who focus on fundamentals rather than short-term noise.
Looking ahead, we see further catalysts for recovery. Declining inflation and stabilising interest rates provide a more conducive environment for mid-cap earnings to flourish. Additionally, the increased emphasis on capital discipline and strategic reinvestment among management teams ensures that shareholder returns remain a priority.
A disciplined approach to value creation
At Downing Fund Managers, our investment philosophy revolves around capital discipline. We prioritise companies that use cash efficiently—whether through reinvestment for growth, de-gearing, or returning cash to shareholders via dividends and buybacks. By focusing on quality, recovery, and undervalued opportunities, we aim to deliver consistent returns while mitigating downside risk.
As we move into 2025, UK small and mid-caps remain a fertile hunting ground for value-driven investors. With sentiment at a low ebb and valuations at a discount, the stage is set for this often-overlooked segment to deliver robust returns in the years ahead.
Josh McCathie
Fund Manager, VT Downing Small & Mid-Cap Income Fund
Opinions expressed represent the views of the fund manager at the time of publication, are subject to change, and should not be interpreted as investment advice.
Important notice: Capital is at risk and investors should note that their investments and the income derived from them can fall as well as rise and investors may not get back the full amount invested. Past performance is not a reliable indicator of future performance. Any subscription to the fund should be made on the basis of the relevant product literature available from Downing or from the ACD, Valu-Trac; and your attention is drawn to the charges and risk factors contained therein. Downing does not offer investment or tax advice or make recommendations regarding investments. Downing is a trading name of Downing LLP. Downing LLP is authorised and regulated by the Financial Conduct Authority (Firm Reference No. 545025). Registered in England and Wales (No. OC341575). Registered Office: 10 Lower Thames Street London EC3R 6AF.
