Two compact investment vehicles, exhibit signs of growth in their sectors.

In the dynamic world of investment, the small-cap sector continues to hold a significant place, offering potential growth opportunities that outweigh those of larger companies. This is evident in the UK market, where the FTSE Small Cap index has been a subject of interest recently.

According to a prediction by investment bank Peel Hunt, the number of companies in the FTSE Small Cap index could fall from 160 in 2018 to 114 by the end of 2023. This potential reduction in the index's constituents has sparked discussions about the index's possible cease to exist by 2028.

Looking back, the Numis Smaller Companies index has shown a robust performance, compounding at 14.1% per annum since 1955, compared to the FTSE All-Share index's 11% return. Despite this, small caps have underperformed since 2016 and currently trade at less than 12 times expected earnings.

However, the underperformance seems to have created an opportunity for investors. Historically, when small caps were this cheap, average returns have been 22% over the next 12 months and 42% over the next 24 months.

Two investment companies, Rockwood Strategic and Odyssean Investment Trust, have been actively seeking companies with exceptional prospects and shaping their management and strategy. Notable holdings in Rockwood's portfolio include RM, an education market supplier (11.6% of the portfolio), NCC, a cybersecurity consultant (14%), Xaar, an inkjet manufacturer (9%), and Dialight, an industrial LED specialist (6%).

Filtronic, a key contractor for SpaceX's Starlink phones network, accounts for 10% of the portfolio. The company has gained significant value after SpaceX acquired warrants in the company, giving it a market value of £160m.

Meanwhile, Odyssean Investment Trust's largest holding is not publicly disclosed, but it has returned 66% over the last five years. Rockwood Strategic, on the other hand, has shown a more impressive performance with a return of 129% over the same period.

Despite some concerns about specific holdings, such as Capita being considered a blind spot in the UK market, the potential for growth in small caps remains enticing. The FTSE 100, for instance, trades at a 15%-20% discount to its long-term average.

One recent development that underscores the growth potential of small caps is RM's new contract with International Baccalaureate worth £100m. This contract underpins growth of 10% per annum and 22% margins, providing a promising outlook for the company and its investors.

Staveley, another player in the market, has bought 3% of lending platform Funding Circle, despite the platform never making a profit despite £175m of unrestricted cash. This move, along with others in the small-cap sector, suggests that investors continue to see potential in the small-cap market, despite the challenges it presents.