Small-cap stumble deters buyers

The UK smaller companies sector has outperformed over the last three years, but a growing aversion towards risk may be driving investors back to the relative safety of large-caps.

Funds investing in British smaller companies have performed well over the past three years. The UK Smaller Companies sector has returned 47.2% on average in the three years to June 27, according to Standard & Poor’s.

Recent sales, however, have not been as robust. According to the Investment Management Association, in May it was the UK Smaller Companies sector that was ranked as the worst-selling sector, with net retail outflows of 69m. In comparison the best-selling IMA sector in May, UK Corporate Bond, had inflows of 127m.

In the previous month, the UK Smaller Companies sector also saw significant net retail outflows of 56m – only slightly behind those of the Europe excluding UK and the North America sectors.

This is a substantial drop from January’s retail sales figures for the sector, which totalled just over 8m. But what has been the catalyst for retail investors’ recent move away from British smaller companies?

The recent period of outperformance may itself be one of the reasons behind the decision by retail investors to redeem some of their holdings in smaller companies. According to Trustnet, UK Smaller Companies is one of the five top-performing sectors over the past year. On the other hand, the sector is the worst performer over the past three months.

Darius McDermott, managing director of Chelsea Financial Services, comments: “Smaller companies have had a great run, but even the average smaller companies fund is down in value over three months. I would suggest that the dip in performance has led to that outflow.”

Paul Marriage, head of UK smaller companies at Insight Investment, says it is no surprise that the sector is currently less popular than it has been in previous years. “People who buy small-cap funds buy a higher-risk product. If you have a good run from a high-risk product, maybe you decide it is time to move on to the next thing,” he says, adding that the long-term prospects for the sector are still positive.

Ruth Keattch, co-manager of the DWS UK Smaller Companies fund, launched earlier this year, adds that “small-caps have had such a good run over the last couple of years that they are probably due to give a bit back.”

Most of the outflow from the sector also seems to be returning to the safety of large-cap stocks, according to some small-cap managers.

Catherine Stanley, head of UK smaller companies at F&C Asset Management, says that on the institutional side there was money coming out of small-caps in favour of large-caps earlier this year. She adds that this was one of the reasons for the poor performance in the sector. Keattch agrees, saying that the market has recently seen a move towards large-caps, as the sector is perceived as being less risky.

She adds that questions about the potential risks of the Alternative Investment Market have hit investor sentiment on the retail side. According to Keattch, the situation surrounding one particular company, Regal Petroleum, dampened the Aim story this year. It raised questions about the quality of companies listed on Aim, specifically within the resources sector. This resulted in a slowdown in the performance of Aim stocks, she adds.

That particular stock has fallen from over 500p per share in March to its current level of about 100p, according to the London Stock Exchange. “There has been a quality flight to bigger companies as a risk-reduction exercise,” says Keattch.

Paul Jourdan, manager of the British Smaller Companies fund at First State, also recently noted that “confidence remains fragile for small companies, while the queue of companies coming to the market continues unabated”.

In terms of valuations, says F&C’s Stanley, small-cap stocks are currently similar to mid-caps, with 13% earnings growth on average. While she adds that this is not cheap, it is also not as bad as the small-cap valuations of the early 1990s, she says.

According to McDermott, the easy money in the small cap sector has already been made. “Small-caps were trading at a discount to their large-cap rivals, but the discount has now disappeared,” he explains.

Ben Yearsley, investment manager at Hargreaves Lansdown, says the reason for investors’ recent aversion to British small-cap equities is simple: “A certain percentage of the investor population will follow what is performing well. Smaller companies have not performed well this year; the hot money hasn’t followed the sector.”

While returns may not currently be as spectacular as they have been over the last one and three years, there are opportunities for fund managers doing due diligence to find good-quality small-cap companies, says McDermott.

Stanley notes: “From a demand and supply point of view, there is still demand from initial public offerings, with cash going into new issues.” She adds: “There is still plenty of demand in the market for decent new issues, as this is one of the only places you can buy growth at the moment.”

Looking ahead, Insight’s Marriage adds that the market is likely to see a period of catching up for large and mid-cap stocks. Many managers in the sector are also maintaining that a favourable outlook for the economy will prove positive for smaller companies. In particular, an interest rate cut would be good news for British small-cap stocks, as they tend to be more focused on the domestic market, says DWS’s Keattch.