With the new year underway, we reflect on the mid and small cap companies that stood out in 2025 and outline the team’s expectations for 2026.
UK mid and small cap stocks
UK mid and small cap stocks, as represented by the FTSE 250, have outperformed the FTSE 100 index of large cap stocks, and all other major markets except the US, over the long term¹. This strong performance is due to the superior growth of mid and small cap companies, relative to the mature and less innovative businesses which comprise the FTSE 100. The Mercantile targets good quality, attractively priced companies in this space, which the management team believe capable of delivering above market returns over a five-year period. Typically, these businesses operate in growing end markets and have shown themselves to be capable of adapting to the changing environments in which they operate.
This approach has proved very successful, as the trust’s long-term returns have outpaced the FTSE 250 and broadly matched the S&P 500¹. In the 10 years ended November 2025, the trust has delivered an average annualised return of 6.5%, comfortably ahead of the FTSE 250’s average annualised return of 5.10%².
2025’s winners
Despite the disappointing results of a few portfolio holdings during 2025, strong returns from other positions underpinned The Mercantile’s robust outright gains over the year. Contributors to returns included a longstanding, significant holding in 3i Group*, a private equity firm that invests in mid-market companies based in northern Europe and North America. 3i did very well, driven by continued excellent sales and profit growth from Action, a discount retailer which now represents about 60% of 3i’s investment portfolio³. Serco*, a government outsourcer operating in many sectors including defence in the UK, Europe and North America, was another key contributor to performance. This company won more contracts over the past year, as countries on both sides of the Atlantic lift defence spending, and growth is expected to accelerate accordingly. Yet the stock is still trading at an attractive valuation, with potential to re-rate over time. A position in Plus500, a provider of online trading services, also delivered further gains, following significant growth in its new US futures business. It also benefitted from the surge in market volatility in early 2025.
The team’s decision to avoid some names also enhanced returns. For example, their decision not to hold B&M* European Value Retail, a discount retailer, and food company Tate & Lyle*, made meaningful contributions to relative returns over 2025, as both these names underperformed the index.
Outlook for 2026
The Mercantile’s management is optimistic about the outlook for UK mid and small cap companies over the coming year. The Bank of England (BOE) cited ‘subdued growth’ and softening labour market conditions as justification for its decision to reduce interest rates in December 2025⁴. However, the trust’s managers believe that companies are doing better than the BOE’s relatively gloomy assessment suggests. This view is based on the 400-500 company meetings the team conduct each year, which give them valuable insights into conditions ‘on the ground’ in businesses around the country. While consumer facing businesses are undoubtedly having a tough time, the team reports that UK corporate and consumer balance sheets remain broadly healthy, with many portfolio holdings executing well despite the relatively downbeat mood permeating the media, and consumers, as well as the central bank. And with interest rates still declining and policy uncertainties resolved by the delivery of the government’s November 2025 Budget, the managers expect portfolio companies to maintain their strong performance in 2026.
Other developments over the past year also bode well for the year ahead. UK equities were supported over 2025 by increasing interest from foreign investors⁵, who are apparently finally coming to appreciate the great value offered by the UK market, especially among mid- and small-cap stocks. These inflows are due in part to investors rotating away from the US. With UK equity valuations remaining at significant discounts to both their own history and relative to other developed markets, and mid and small caps trading at a sustained discount to large caps, rather than their usual premium, there is good reason to expect further investor inflows in 2026.
Another manifestation of increasing investor interest in the UK market is the surge in mergers and acquisition (M&A) activity - 10% of the mid cap market has been the subject of takeover bids over the past year, at an average 30% premium to market price⁶, and this activity is likely to be sustained while ever corporate buyers and private equity investors see attractively-priced opportunities. Low share valuations are also encouraging companies to buy back their own shares, and this may provide additional impetus to UK equities in the coming year.
In sum, 2025 was a rewarding year for investors in UK equities, and conditions seem ripe for 2026 to be just as good, if not better. The Mercantile team’s confidence in the outlook for the UK market, and the trust’s portfolio holdings, is illustrated by the level of portfolio gearing, which is currently at 14.5%⁷ - towards the upper end of its long-term range. And the team is, as ever, braced to grasp other compelling opportunities as they emerge, and to make the most of the favourable tailwinds likely to propel the market in the year ahead.