When people think of investing in shares, the first names that often come to mind are household brands like BP, Unilever or Tesco – the so-called “blue chips.” But beneath the FTSE 100 lies another, often overlooked layer of the stock market – small-cap stocks.
These are shares of smaller companies, usually with a market capitalisation of under £500 million. Although they are less well-known and often more volatile, small-cap stocks can offer investors the chance for significant long-term returns, particularly if you can identify businesses early in their growth journey.
This guide will walk you through what small-cap stocks are, why they matter, how to identify opportunities, and how to build a strategy for investing in them as part of your UK portfolio.
What Are Small-Cap Stocks?
In the UK, small-cap companies are typically listed on the FTSE SmallCap Index, the FTSE Fledgling Index, or the AIM (Alternative Investment Market). These firms are generally smaller, younger, or more niche than their large-cap counterparts.
While there’s no fixed definition, a small-cap company typically has:
- A market cap between £50 million and £500 million
- Lower daily trading volumes than FTSE 100 or FTSE 250 stocks
- Greater potential for high growth — and higher risk
Examples of past UK small-cap success stories include Fever-Tree, ASOS (in its early days), and Jet2. Many well-known businesses began their journey as small-cap stocks.
Why Invest in Small-Cap Stocks?
There are several compelling reasons for investors to consider adding small-caps to their portfolios:
1. Higher Growth Potential
Smaller companies are often more agile, innovative and operate in niche or emerging markets. If they grow rapidly, the share price can appreciate dramatically.
2. Less Analyst Coverage
Big institutions tend to focus on larger companies. That means small-caps can be under-researched and undervalued, offering opportunities for individual investors to find hidden gems.
3. Portfolio Diversification
Small-caps tend to behave differently to large companies and may outperform in certain market cycles. Including them can provide diversification benefits.
However, this opportunity comes with greater risk, including limited liquidity, greater volatility, and sometimes a lack of transparency.
Where to Find UK Small-Cap Stocks
UK small-cap companies are primarily listed on the following markets:
1. FTSE SmallCap Index
This includes smaller companies listed on the main London Stock Exchange that don’t qualify for the FTSE 100 or FTSE 250.
2. AIM (Alternative Investment Market)
AIM is home to a large number of UK and international growth companies. It offers a more flexible regulatory environment to help small businesses raise capital. AIM stocks can range from speculative biotech firms to solid, fast-growing consumer brands.
3. The FTSE Fledgling Index
An index for companies that are too small to qualify for even the SmallCap index.
Each of these markets has different levels of risk, so it’s important to research carefully.
How to Research Small-Cap Stocks
When investing in small-caps, research is essential — often more so than with larger firms.
1. Understand the Business Model
Can the company scale? Does it solve a real problem? Look for sustainable competitive advantages or niche expertise.
2. Evaluate the Financials
Many small companies won’t be highly profitable yet, but you should look for:
- Strong revenue growth
- Positive cash flow, or a clear path to it
- Low (or manageable) levels of debt
- Reasonable profit margins in future forecasts
3. Check the Management Team
With small-caps, the management team is often the deciding factor. Are they experienced? Do they have skin in the game (i.e. do they own shares)? Have they delivered results before?
4. Market Opportunity
Is the company targeting a growing industry or trend? For example, clean energy, cloud software, or specialist manufacturing.
5. Balance Risk and Reward
Small-caps can go through long periods of underperformance or even failure. Look for resilience in downturns, not just headline growth figures.
How to Invest in Small-Cap Stocks
1. Use a Suitable Investment Platform
Most UK platforms like Hargreaves Lansdown, AJ Bell, Freetrade, and Interactive Investor allow access to small-cap and AIM-listed shares. Some offer better research tools and liquidity data for these smaller names.
2. Use a Stocks and Shares ISA
You can invest in small-cap stocks within an ISA to shelter gains and dividends from tax. Note: not all AIM shares are eligible, so double-check before investing.
3. Diversify Your Holdings
Due to higher risk, it’s important to diversify. Rather than putting 10% of your portfolio into a single AIM share, consider spreading that amount across 5–10 smaller companies in different sectors.
4. Consider Small-Cap Funds or Investment Trusts
If you’re unsure about picking individual shares, there are many actively managed UK small-cap funds and trusts, including:
- BlackRock Smaller Companies Trust
- Marlborough UK Micro-Cap Growth Fund
- Henderson Smaller Companies Investment Trust
These give you diversified exposure to expert-managed baskets of small-cap companies.
5. Have a Long-Term View
Small-caps are not for short-term trading. Their prices can be erratic, and results may take years to play out. Aim for a horizon of 5–10 years or more.
Tax Considerations for Small-Cap Investors
Investing in small-caps through an ISA or SIPP (Self-Invested Personal Pension) is usually the most tax-efficient route. Many AIM shares are also exempt from Inheritance Tax after two years of holding, if held through qualifying Business Property Relief.
However, this area is complex and subject to change, so always check the latest rules or consult a tax adviser.
Risks of Investing in Small-Cap Stocks
Investors should be aware of the potential downsides:
1. Volatility
Prices can move rapidly and irrationally due to low trading volumes and sentiment shifts.
2. Lack of Liquidity
It may be harder to buy or sell shares quickly, especially in thinly traded stocks.
3. Business Risk
Many small companies are unproven or reliant on a few contracts or markets. Failure to meet expectations can result in steep declines.
4. Limited Information
Not all small-caps provide the same level of disclosure or research coverage. This increases the importance of doing your own due diligence.
Final Thoughts
Investing in UK small-cap stocks can be incredibly rewarding — but it’s not for the faint-hearted. With greater return potential comes greater risk. The key to success lies in careful research, patient holding periods, and a diversified approach.
If you enjoy analysing businesses, spotting trends early, and taking a hands-on approach to investing, small-caps can provide exciting opportunities. For those who prefer a steadier hand, small-cap funds or trusts might offer a more balanced route.
As always, never invest more than you can afford to lose and ensure that small-caps are only a part of a broader, well-diversified portfolio.