Good things come in small packages

British smaller companies have suffered heavy losses, however, small-caps are outperforming large-caps so far this year. Is this yet another “false dawn” or are small-caps the way to go?

British smaller companies stocks endured heavy losses in the last quarter of 2008, as the economy slid towards recession, and oversold sectors such as oil and gas enjoyed a rally into the calendar year end. This year though, there has been a reversal of the trend as mid and small-caps have outperformed large-caps. “Stocks such as insurance companies and banks in the big-cap index have done extremely badly,” says Harry Nimmo, manager of the Standard Life UK Smaller Companies trust. “We’re mid and small-cap and those have done relatively better. Our net asset value is pretty much flat for the year.”

In February this year, shareholders approved the merger of the Standard Life trust and its Gartmore counterpart – Gartmore Smaller Companies. The move, which doubled the assets under management of the Standard Life vehicle to £63m and saw the Gartmore trust wound up, took the form of the creation of a continuation share class for the Gartmore trust shareholders.

“The assets have been ring-fenced for 12 months while we rebalance and restructure,” says Nimmo. “Every quarter, that bit of it which has been rebalanced goes into the Standard Life trust. The idea of this was that we were keen our ongoing shareholders wouldn’t have to bear the expense of restructuring and to give ourselves 12 months to do the job, so we weren’t forced sellers and in order to protect the Gartmore shareholders. The Gartmore trust had a large number of small holdings in pretty small companies.”

About 68% of Gartmore shareholders chose to transfer into continuation shares in the Standard Life trust, while 8% chose a cash exit and 24% chose to receive their underlying shares. The merger was proposed in November last year, after concerns over the large discount on the Gartmore fund.

Standard Life UK Smaller Companies has outperformed its Extended Hoare Govett Smaller Companies index benchmark over the past five years. It is also ahead of the UK Smaller Companies sector average over one, three and five years to March 23, 2009, according to the Association of Investment Companies (AIC).

About 20% of the portfolio is exposed to online business models such as Asos, the fashion retailer, and Abcam, which produces and distributes research-grade antibodies and has delivered strong results with double-digit earnings figures. “You will find quite high P/E [price/earnings ratio] stocks in the fund,” says Nimmo. Other significant sector positions include healthcare, which makes up 10% of the portfolio, and software, which accounts for about 15%.

Nimmo describes the market as strange. “There’s quite a lot of fund raising going on and a lot of investors calling the bottom. There seems to be a perpetual oscillation between recovery and defensive stocks.” In this environment, he says, it has been essential not to try and second-guess the market but to stick to his investment philosophy. This essentially aims to identify improving opportunities which are not fully recognised by the market, focusing on fundamentals and seeking out companies with strong balance sheets and resilient earnings.

“There are three stages, which are growth, momentum and quality-orientated. We like strong visibility of earnings. We run our winners and cut our losers.” Nimmo also utilises Standard Life’s in-house research matrix which analyses criteria such as price momentum, earnings momentum, P/Es, under-owned shares, and balance sheet and cash flow strength. “We test the resilience of the business model, looking at barriers to entry and control over pricing. We also check for rogue numbers.”

Using this approach means that in recovery markets, the trust is likely to go through an initial period of underperformance. “That’s been the experience of 2003 and 1999,” he says. “But, you get outstanding absolute returns even though you’re slightly behind the benchmark. We feel it is right to stick with the process and we don’t see why this shouldn’t continue. It’s quite difficult to tell when a recovery point is actually happening – in the last year there have been three false dawns.”

Simon Elliott, head of research at Wins Investment Trusts, says Nimmo’s distinctive, quantitative-driven approach helped him be top of the pile over one and three years. “The issue we always had with this fund was it had a tender offer a few years ago which shrank the fund.” The merger with the Gartmore trust is important in Elliott’s view. “It makes it a far more attractive vehicle. Eventually the fund itself will grow substantially – our major fear was liquidity. It’s a fund we’re recommending at the moment.”


Standard Life UK Smaller Companies