Too late to catch the small-cap bus?

AFI panellists are among the many investors looking back in chagrin after failing to get in on the smaller companies’ rally. The question is, will small-caps continue to defy expectations?

There is a good reason why this has become known as the miserable rally: no-one seems to be in it. And if they are, they are holding nice, sensible, defensive things like large companies, so they have missed out on the phenomenal performance of smaller companies.

As Hilary Coghill, the chief investment officer of City Asset Management, says: “In the AFI I don’t have a dedicated smaller companies holding. In the last six months I have wished that I had.”

The question is whether investors are too late to get into the small-cap recovery story.

The share price performance of smaller companies in the UK has been off the charts. In the past six months the FTSE SmallCaps index, which covers companies outside the FTSE 350, has risen about 65%, while the FTSE 100 has made gains closer to 30%. Even within the 350, performance has outstripped the FTSE 100.

So is it too late to buy into the rally?

There is an argument that this is less of a boom than a bounce. In 2008 smaller companies had their worst year since 1974, and had fallen to such a low level that there was nowhere else to go.

Coghill says: “Some of the cyclical companies in the sector were priced to go bust, but they didn’t and the consumer held up well because the oil price fell and their mortgage repayments fell, so they still had disposable income.”

There was not anything particularly positive in the market, small-caps were just priced for the worst case ­scenario, and that worst case never hit, so they bounced.

That is one reason why so few investors had bought into the market at the bottom: there was simply no compelling ­reason to do so. Most AFI panellists did not have a small cap-specific exposure, preferring to hold funds that have the freedom to invest in smaller companies when the ­timing is right, such as special situations funds.

Panellists are in no great hurry to buy into the smaller companies rally either. Graham Toone, the head of investment research at AFH Independent Financial Services, says: “They have had a fantastic run and they are fair value now. I wouldn’t have said they were a roaring buy, and our strategy is neutral.”

One reason is that in the short-term the whole ­market, and smaller companies in particular, is expected to pull back from the highs.

Jonathan Wallis, the director of re­search at Allenbridge, says: “How much of a pull-back we get is very difficult to tell. There seems to be an incredible momentum behind the markets, but it is bound to pause for breath and we will see a bit of a sell-off.”

Mick Gilligan, the head of research at Killik, agrees: “I wouldn’t be at all surprised. Things technically look a bit hot at the moment.”

In the medium-term, panellists expect market conditions to remain tough. Coghill says: “Funding will be very difficult. The companies that get access to capital at ­reasonable rates are likely to be much stronger than those who do not. A lot of AIM–listed companies are saying that funding is still very expensive.”

Trading is also going to be lacklustre. “A lot of smaller companies are very domestic-oriented and we are fairly negative on the UK economy,” says Coghill.

Toone agrees: “Our concern is over the possibility of a double-dip recession when the government starts reining back spending,” he says. “That might not be until next year, but it remains a risk.”

In the long run there are opportunities for the sector, although Coghill emphasises that performance will vary widely and Wallis agrees it will be a mar­ket for the strong stock-picker. Wallis also underlines that the fact that so many investors missed the rally means “a lot of people aren’t in the market, and a lot of money is waiting to come back in when it does go down, so it won’t fall too far”.

However, overall the panellists tend to favour the larger-caps. Toone says: “Our focus is on the larger-caps, especially multinational companies.” These have the international exposure and the financial resilience to weather the tougher times, he adds.

In addition, Gilligan says that larger companies trade better when the markets are struggling, a situation that had a major impact on smaller companies in 2008.

“Given the headwinds, over the next three to five years we would prefer funds that have liquidity in their favour, which means the larger companies,” says Gilligan.

Smaller companies may not offer the potential of their larger counterparts at this stage in the cycle.

Coghill says: “We are more optimistic about larger companies. Over the past six months mid-caps and small-caps outperformed, but for this recovery to be sustainable we need large-cap participation in it as well.”

However, panellists also agree that before this most recent bounce, pundits were tipping larger companies as the robust favourites for the recession, so smaller companies have already defied expectations; whether they continue to do so remains to be seen.