Anthony Cross, head of the Liontrust economic advantage team and co-manager of Liontrust Special Situations (GB00BG0J2688)
Today, the case for investing in UK mid-cap and small-cap companies boils down to the wide choice and compelling valuation. Unlike the FTSE 100, which is concentrated by companies and certain sectors, an investor in UK mid and small caps is confronted by endless opportunities across hundreds of companies.
A portfolio can be tailored to capture certain company characteristics such as an abundance of intellectual property, distribution strength or recurring income. These companies have strong defensive moats that allow them to fend off competition and earn high returns on invested capital. They can be found in sectors such as specialist engineering, software, wealth management, data-driven media businesses and healthcare. They also frequently have a high percentage of overseas sales and are, therefore, not that tied into the vagaries of the domestic UK economy.
While such UK-listed mid-cap and small-cap businesses are no more cyclical than many FTSE 100 companies, they have, along their long-term journey of relative outperformance, experienced bouts of sharper share price pullbacks. Indeed, over the past four years the share price performance of many such companies has been poor versus the FTSE 100. Therein lies the valuation opportunity. Today, numerous companies have the sort of free cash flow yields last seen during the 2008 financial crisis. When we look at their price/earnings (PE) ratios, many are at over a 30 per cent discount to their 10-year average.
For those that are nervous about the domestic UK economy in 2026, there is plenty of choice among mid-cap and small-cap stocks that will give you exposure outside of the UK and at compelling valuations.
Should investors diversify away from the Magnificent Seven next year?
Cormac Weldon, head of US equities at Artemis and manager of Artemis US Select (GB00BMMV5105)
The Magnificent Seven are a unique cohort of companies that have demonstrated exceptional financial results. They possess several winning characteristics, any of which alone would have attracted investors. Their strong earnings growth is unusual for companies with such large market capitalisations and, surprise, surprise, they have been rewarded by a market that is focusing on earnings momentum, almost to the detriment of all else.
They are either oligopolistic businesses or have significant market shares, driving their profitability, and the cherry on top of the tech cake is high free cash flow.
Hyperscalers (companies with large-scale data centres such as cloud providers, including Amazon (US:AMZN) and Microsoft (US: MSFT)) view artificial intelligence (AI) as both an existential threat and an opportunity, and they fear being left behind if they don’t invest in it heavily. As AI capex renders these businesses more capital intensive, they are likely to become less free cash flow generative and perhaps less profitable.
We also expect AI to generate more competition within the industries where hyperscalers are dominant, such as advertising and cloud computing. OpenAI could potentially mount a challenge to Microsoft within the field of productivity software, for example.
However, we feel it is too soon to tell who the winners and losers from AI will be. A year ago, many commentators felt Alphabet (US:GOOGL) would be a loser, but now it has one of the best AI models, is growing its share of eyeballs and remains the ‘king of search’. Any investors who sold Alphabet last year would have missed out.
Ultimately, we think it is too soon to make large bets either way on the outcome of the AI capex race for hyperscalers, so we do not believe it is time to move away from the Magnificent Seven.
Diversification, however, is always sensible and there are other themes within our portfolio beyond AI. Investment banks have been performing strongly and we expect them to continue benefiting from deregulation and, potentially, an uptick in merger and acquisition activity.
We are also taking active positions in companies we expect to benefit from AI capex, such as power companies. Nvidia (US:NVDA) is part of this theme, but there are many more aspects involved in constructing data centres beyond Nvidia chips. Someone has to flatten the land, lay the concrete, build facilities, install storage equipment and connect the power, so we would argue there are opportunities that include a wider group of businesses.
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European banks helped power a rally for the continent this year. Which sectors look best placed for 2026?
Niall Gallagher, investment manager of Jupiter European (GB00B5STJW84)
European banks performed extremely well this year. A lot of clients are now asking us how much longer this can continue, and whether European banks ‘are done’. I don’t think that is the case for a variety of reasons. Firstly, the sector continues to see positive earnings revisions relative to the broader market, and it is also enjoying rising returns on equity, both of which are usually strong signals of future outperformance.
The sector also experienced a number of key return-on-equity improvements, such as significant consolidation, the movement of many banks into the private sector from the savings and mutual sectors, and a large amount of de-risking and deleveraging, which has improved the quality of balance sheets. We also believe that banks are likely to be a major beneficiary of AI and automation given the number of rules-based processes inside banking businesses.
The European banking sector also remains fundamentally cheap when we consider price-to-book multiples versus the achieved return on equity. This suggests the market is implying a decline in return on equity, but we do not think that is likely.
Can India’s stock market recover its poise next year, and if so why?
Abbas Barkhordar, manager of Schroder AsiaPacific (SDP)
Investors in Indian stocks are likely to have been disappointed with the performance of the overall market in 2025 so far, although in absolute terms the MSCI India index has merely gone sideways, with a flat total return (when measured in pounds sterling) from the start of the year to the end of November.
On the face of it, this relatively weak performance is surprising. Domestic politics has been largely stable in India this year, and while pockets of the economy have been soft, overall GDP growth remains high by global standards, with the latest quarterly growth rate of 8.2 per cent hardly suggesting the growth story is faltering.
So why has the market struggled relative to its peers across the region? A significant part of the explanation is the starting point: India returned almost 37 per cent across 2022, 2023 and 2024 – well ahead of the wider Asian index return of just 3 per cent. This outperformance had led it to look very expensive against the region entering this year.
Starting valuations are often a key factor in subsequent returns, and so it has proved this year as realised Indian corporate earnings growth has been offset by a derating of the market, leaving returns close to zero. Not helping matters, a trade dispute with the new Trump administration has left India facing some of the highest trade tariffs globally, at least for now.
Moreover, one of the key drivers of the other large Asian markets – China, Korea and Taiwan – has been the extraordinary boom in spending on AI by US and Chinese tech companies. India has few companies that are direct beneficiaries of this spend, so has been left on the sidelines of this powerful trend this year. Perhaps unsurprisingly, foreign investors have been net sellers of the market this year.
There are reasons to expect next year could be a better one for Indian investors. Firstly, policymakers have moved to ease both fiscal and monetary policy throughout 2025, which should support growth into next year. Secondly, while valuations are by no means cheap yet, there has been a significant relative derating, which leaves Indian stocks at a better starting-off point heading into 2026 than a year ago. If investor concerns around the sustainability of the AI spending spree continue to build, India could be seen as a relative safe haven in Asia. And finally, if (as expected), a trade agreement is reached with the US, sentiment towards the market should improve, as foreign direct investment and expectations for export earnings start to recover.
Will rising bond yields and fiscal stimulus prove more of a threat or an opportunity for Japanese equity investors next year?
Richard Aston, portfolio manager of the CC Japan Income & Growth Trust (CCJI)
Japanese government bond yields have risen to multi-decade highs, as the market expects Prime Minister Sanae Takaichi’s administration to deploy aggressive levels of fiscal stimulus. The proposed stimulus packages aim to support households and industry, but have raised concerns about debt sustainability, as the country’s gross debt-to-GDP exceeds 250 per cent.
The risks connected with this type of approach have recently been highlighted in the UK, during the short stewardship of the Liz Truss government — when fear of her Budget plans undermined economic confidence, leading to volatility across equities, bonds and currency markets. The risk of systemic failure has become an important consideration for investors in all asset classes, which should not be ignored.
While the situation may look precarious from a simple comparison, we must recognise the many differences between Japan and the UK. These include the high domestic ownership of the government debt in Japan, the country’s current account surplus and the implications of the return of inflation.
Recent movements in the bond market place additional pressure on the Bank of Japan’s yield curve control policy, as well as its ability to maintain a focus on normalisation after years of easy monetary conditions. The bank’s credibility is a vital component of the outlook.
Looking forward, sustained inflation has a positive impact on government revenue and GDP. The projections for Japan’s fiscal situation improve significantly if the negative aspects, such as the rising cost of living, can be offset by improved productivity. A continuation of recent successes could place Japan in a much more credible sovereign debt position compared with its international peers down the line. Government policy and corporate governance reforms are key in achieving these goals.
For equity investors, these potential developments could have many positive connotations in terms of the earnings outlook. Combined with record shareholder returns and structural shifts in household asset allocation, the tailwinds that have driven the strong performance of the Japanese market in recent years remain in place and are unlikely to be derailed, even as bond yields rise gradually.
Can Chinese equities continue to climb next year, even if the tech ‘bubble’ pops in the US?
Chris Tennant, co-portfolio manager of Fidelity Emerging Markets (FEML)
A pullback in US tech stocks could create a more risk-off environment across the world. But it might also accelerate investors’ desire to diversify away from the US, towards emerging markets such as China – where valuations still look cheap and there are plenty of good investment opportunities, at least for the active investor who can avoid the more challenging parts of the market.
Various factors could drive a continued re-rating in China, even in a risk-off environment. High levels of domestic savings and a lack of alternatives for savers’ money other than the local equity market could drive a speculative rally in A-shares. Signs that the government’s ‘anti-involution’ initiative (aimed at reducing intensive competition) is reducing excess capacity would also be helpful, although we have not seen much tangible evidence of this yet. And if we keep seeing the kind of technological innovation we have seen this year in sectors where China is the clear technological leader, such as automation and batteries, this could underpin earnings resilience and attract flows even in a more cautious market.
China remains a complex market and there is downside risk: property remains weak, consumption is muted and banks look challenged. But if you are an active investor, we think there is money to be made in the market. We particularly like technological leaders in areas such as batteries and electrical equipment, as well as underpenetrated ‘experiences’ categories such as music streaming or travel.
Ultimately, China could benefit from global investors’ desire to diversify if US tech pulls back. But we remain cautious and focused on high-quality compounders that benefit from plenty of fundamental and valuation support too.
Do emerging markets require further weakness in the dollar if the rally is to continue in 2026?
Chetan Sehgal, portfolio manager of Templeton Emerging Markets (TEM)
A softer US dollar tends to ease external financing conditions for emerging markets, as well as supporting capital flows and relieving pressure on countries with dollar-denominated debt – which historically correlates with better equity performance across emerging markets.
Dollar weakness has helped emerging markets in 2025, but it has been a supportive factor rather than the main engine of returns. The key drivers have been country and company level fundamentals. Several key emerging markets have re-rated on the back of strong earnings revisions, improving growth trajectories and policy support, rather than purely due to currency movements.
Looking into 2026, any further weakness in the dollar driven by interest rate cuts could be supportive for emerging market currencies. However, it is unlikely to overturn the primacy of fundamentals – the focus should remain on growth and corporate earnings.
Taiwan and Korea exemplify these fundamentals, particularly when it comes to their technology sector. AI continues to be a strong growth area, despite uncertainty around the monetisation of large investments. Chinese internet platforms are also benefiting from the technology.
Brazil offers a different but complementary opportunity. Policy rates have peaked, and forthcoming rate cuts should support domestic demand and equity valuations. Mexico should continue to benefit from its geographical proximity to the US.
While not without their own risks, emerging markets represent a diverse and unique opportunity for active investors. They have structural advantages such as technological leadership in high-growth industries, including AI, higher growth rates and attractive demographics. We continue to seek high-quality business with solid balance sheets, competitive advantages and attractive valuations.
Global investing increasingly focuses on megacap companies. What’s the investment case for other parts of the market next year?
James Harries, co-fund manager at STS Global Income & Growth Trust (STS)
The US equity market is fully valued and highly concentrated. The S&P 500 trades on a cyclically adjusted PE ratio of 40.3 times – a level last seen during the dotcom boom in 2000.
The top 10 companies in the S&P 500 account for 27.8 per cent of the index. Perhaps more significantly, eight of these are technology companies (broadly defined), which to a greater or lesser extent have been driven up by excitement around AI.
If investors begin to question the likelihood of earning an acceptable return on the incredible sums being spent to build out AI infrastructure, these companies are likely to suffer material, correlated declines.
While the index reaches new highs, opportunities elsewhere are appearing. A combination of nascent fears about the softness of the labour market, concerns about the disruptive impact of AI, and questions around consumer demand has caused several high-quality businesses to fall to attractive levels. In the STS Global Income and Growth Trust, we seek to balance income, quality and growth.
The narrowness of the recent market advance, combined with rich valuations amid economic and geopolitical uncertainty, leads us to a cautious view. We have exposure to sectors that combine durability and value, such as branded consumer goods, enterprise software and healthcare, which should serve investors well if current market trends change.
Indeed, many of the companies are good value relative to their own history, in sharp contrast to much of the equity market. Examples include Reckitt Benckiser (RKT), Amadeus (ES:AMS) and Coloplast (DK:CBHD) – highly predictable businesses with strong competitive advantages and a clear opportunity to grow. They have attractive valuations and, although they are substantial businesses, they are a long way from being trillion-dollar megacaps.
There are three areas where we would like greater exposure: consumer, industrial businesses, and non-bank financials. These sectors have a degree of cyclicality; we think valuations are currently rich but may offer opportunities should markets fall. A good example is Nike (US:NKE). Prolonged weakness in the share price, driven by both consumer weakness and strategic mis-steps, has recently enabled us to establish a new investment. This is precisely the type of high-quality franchise company that we are seeking to buy when out of favour – the opportunity to buy shares at a rarely available valuation.
While the outlook is uncertain, valuations are stretched, and investors may be overexposed to an unproven technology, we see plenty of value and opportunities (away from the megacaps) to build a portfolio of high-quality businesses that should reliably compound free cash flow, whatever the future might hold.
Which regions offer the best prospects for dividend growth over the rest of the decade?
Martin Connaghan, senior investment director of Murray International (MYI)
We believe that companies across the globe are well-positioned to deliver compelling dividend growth for investors over the next five years. The era when attractive yields were confined to specific regions or sectors is firmly behind us.
Historically, achieving a competitive yield required significant regional concentration. For example, 25 years ago, Murray International allocated more than half of its assets to the UK, not due to an overly optimistic view of the domestic equity market but because such positioning was necessary to meet its investment objective of providing shareholders with a 4 per cent yield.
Today, the portfolio reflects a far more diversified approach, offering truly global exposure across multiple regions. Looking ahead, we expect Asia, including Japan, and emerging markets in the Middle East and Latin America to exhibit the strongest potential for dividend growth. This outlook is supported by ongoing corporate reforms, evolving capital allocation strategies, strong balance sheets and improved free cash flow discipline.
North America is expected to remain strong. However, the prevalence of share buybacks and the substantial capital expenditure by large-cap technology companies, particularly in areas related to AI, may temper dividend growth prospects. In Europe, yields are likely to remain stable, but given their relatively high starting point, growth rates may appear less dynamic in percentage terms.
As more and more companies prioritise buybacks alongside (or instead of) dividends, should equity income funds consider using capital gains to help fund payouts?
Clive Beagles, senior fund manager of JO Hambro UK Equity Income (GB00B8FCHK57)
The evolving dynamic between buybacks and dividends has been present in the UK for a number of years, and probably began as companies started to reconsider their capital allocation priorities as they recovered from the Covid-19 shutdowns. Prior to the pandemic, a fair criticism that could have been levelled at the UK market was that it over-prioritised dividend distributions compared with other uses of that capital, such as growth capex or buybacks. Indeed payout ratios were typically in the 50-55 per cent range for the average company.
However, partly to give themselves more flexibility, companies have been reluctant to return to these levels of payout, with many now operating in the 30-40 per cent payout range but supplementing those distributions with buybacks. Indeed, some high-profile companies such as Marks and Spencer (MKS) and Barclays (BARC) have only distributed 15-25 per cent of their earnings in recent years. The banks in particular have supplemented this with significant levels of buyback activity.
With JOHCM UK Equity Income, at the aggregate level, companies have broadly been returning the same quantum in dividends as buybacks, with both in the 4.5-5 per cent of market capitalisation per annum range, leading to a total distribution of 9-10 per cent. Some of the banks, for example, have been running closer to 15 per cent. However, this was partly a function of their valuations being so low, which meant that their buybacks could retire disproportionately large percentages of their market capitalisations, particularly in the 2023-24 period. It also reflects the fact that the average stock in our fund sits on a free cash flow yield well above 10 per cent, as part of that cash flow is used for organic and inorganic growth.
As such, we see no need to use capital gains to help fund payout ratios as dividend distribution yields still sit at around 4.7 per cent for our fund. Furthermore, the use of buybacks will help drive accelerated dividend per share growth in future years for our companies due to a lower share count. We also believe that relying upon capital gains to drive distributions is somewhat dangerous and could prove unsustainable. Our fund will continue to focus on modestly valued companies with attractive dividend yields that can grow over time, and this is reflected in the fact that the fund has grown its dividend distribution by around 9 per cent per year for the accumulation share class since launch 21 years ago.
Will fiscal concerns have more of an impact on US and UK government bond yields than monetary policy easing and growth worries in 2026, or vice versa?
Bryn Jones, head of fixed income and lead manager of Rathbone Strategic Bond (GB00B6ZS2486)
With Budget day out of the way, it is what happens now that shows the true colours of what investors think. And gilt yields have been falling.
At the time of writing, the market is pricing in maybe two more interest rate cuts from the Bank of England over the next year, bringing rates down to 3.5 per cent at the end of 2026. My personal view is that the Bank of England might instead cut rates to 3 per cent by the end of next year, implying that two more cuts need pricing in. So, for now, I’ll take the duration, until a few more cuts get priced in.
Another reason to stay in long-duration gilts is the demand-supply dynamic. The Debt Management Office (DMO) is now unlikely to issue any more long-dated gilts in this fiscal year, so there may not be any long auctions or syndications until April.
As for credit markets, while I am not calling an impending credit event, we are getting more defensive for next year on valuation grounds. Basically, we continue to look for places to hide the deckchairs and are checking the lifeboats don’t have holes in them – but we don’t feel the storm is necessarily imminent, and are still out on deck in the sunshine.
In sterling credit, the US and Europe, the market is still risk on. One amazing thing about the credit rally has been the absorption of supply, especially in Europe. November was one of the busiest months on record for the European investment-grade primary market. I think all else being equal, we go into next year with more of the same, and corporate bond demand will remain high.
But risks do seem to be building, with economic data such as unemployment weakening both here and in the US, and real income growth dropping. So for credit spreads, the risks could lie in the weakening of the economy and/or the increasing leverage of tech companies, which is building in both the private and public debt space.
We are positioned to be increasingly “fearful while everyone is greedy”, reducing the credit beta of our corporate bond funds and increasing the overall duration through the use of gilts.
Which alternative asset classes look most attractive next year?
Charlotte Cuthbertson, co-manager of Migo Opportunities (MIGO)
Investment trust discounts exist because demand for shares is lower than supply across almost the entire £250bn sector. This has provided rich pickings for astute investors. However, much of the easy opportunity – buying trusts investing in listed equities – has been arbitraged away.
By contrast, alternative trusts have more complex private asset valuation models that lack daily price benchmarks. Some of them trade at discounts of over 30 per cent, and this is where we see attractive opportunities, particularly within the renewables and private equity sectors.
Valuation scepticism has long undermined sentiment in listed private equity. However, there are opportunities where reported net asset values (NAVs) are fair and conservative, and portfolio company valuations are in line with public-market benchmarks. The secondary market for private equity has grown deep and liquid, with portfolios typically selling at a 5-15 per cent NAV discount – yet their private equity investment company owners trade at double this level.
This gives trust boards a simple arbitrage: sell portfolio holdings at a lower discount and buy the trust’s shares at a wider discount. Governance tools such as continuation votes can catalyse investor action for boards to address persistent mispricing. Other tools, including redemption offers, special dividends, or managed wind-downs can trigger larger capital returns. All have their role, with board decisions driven by constructive shareholder dialogue, as corporate activity restores balance.
A similar arbitrage opportunity exists in the renewable energy trust sector, where caution has dragged on sentiment, driven by governance mis-steps, policy uncertainty and rising interest rates. Years of rapid issuance created a sector crowded with lookalike, sub-scale vehicles. Higher interest rates made income-oriented renewables less appealing than bonds. The resulting sell-off caused share prices to overshoot valuations. High-quality portfolios now trade at distressed levels, and investors can often earn a strong yield while they wait for a recovery.
However, while double-digit discounts can highlight an opportunity, beware the NAV value trap: wide discounts can also mask low-quality portfolios, and narrowing discounts might accompany a stale NAV which turns out to be inaccurate.
