Are UK small-caps coming back into favour?

Ben Yearsley 2012 Portrait 175

As investors’ risk appetite begins to return, are we about to see a renewed interest in UK smaller companies?

Recently, UK small caps have been outperforming their larger counterparts, with many industry experts claiming the long term rewards for the sector are compelling, making the case for UK small caps stronger than ever.

Statistics from the Investment Management Association highlight their strong performance credentials. The average fund in the UK small cap sector is up 19.1 per cent over the last 12 months, outperforming the likes of the UK all companies and UK equity income sectors, both of which have risen 14 per cent.

However attracting liquidity in small caps can be a challenge, making it a risky type of investment, something investors will not easily forget on the back of a liquidity crisis.

Charles Stanley Direct head of investment research Ben Yearsley (pictured) says “It is not challenging to attract liquidity if you are a large cap fund. For example, every single analyst in the world covers Vodafone. So if you are a large cap manager what can you add? What insight can you give? What extra edge? You cannot. They are so well covered and so well analysed, whereas small caps are not. So if you put the time and the effort in as a manager you can unearth some gems of companies who are under owned and you can find some great businesses there.”

F&C Thames River co-head of multi-manager Rob Burdett says small caps can be your enemy as well as your friend, adding investors will have to look at the long-term picture before investing.

He says: “You have to be prepared to brace yourself for volatility in market corrections. You can get the Wile E Coyote effect when the FTSE falls off a cliff and starts diving. Small caps can carry on for a while but eventually people start selling off small caps as well and they fall fast and hard like Wile E Coyote – who hangs in the air for a little while before he falls.”

Despite the risks, Burdett remains positive about small cap investments and says now is a good time to be investing, partly because there is good valuation support. 

The F&C Thames River multi-manager team currently uses the £230m Cazenove UK Smaller Companies fund run by Paul Marriage, and the £200.6m Old Mutual UK Dynamic Equity fund run by Luke Kerr.

Burdett says: “Another fund we keep an eye on is Fidelity UK Smaller Companies fund and I would highlight River & Mercantile UK Smaller Companies’ performance in 2012, which has also been strong.”

Burdett says most small cap fund managers tend to focus on cyclical areas of the market.

He says: “The price earnings ratio on the FTSE small cap index for this year is 10.6 times earnings, falling next year to 9.03 and that is cheaper than mid caps or All-share as a whole. So you start with the valuation discount in small caps at least in the index level. That is quite rare given they quite often trade at a PE premium to the market, so on valuation grounds they look interesting.”

Ignis Smaller Companies fund manager David Clark says: “The attraction of UK small caps is as real now as it has ever been. Basically this is the incubator for the big companies of the future.”

However, Clark says there are plenty of concerns and factors surrounding small caps.

He says: “There are definitely concerns surrounding some of the small caps because of the general state of the macro economic environment. A lot of them are involved in industries that require government funding and we all know government funding is not terribly forthcoming at the moment.”

But Clark adds there arsome companies that are growing quickly and bucking the trend.

Despite the recent strong performance seen in the UK small-cap index, the Ignis Smaller Companies fund has experienced a tough quarter due to poor performance in industrials, according to Clark. The fund is currently fourth quartile in the UK small cap sector in the past 12 months, returning 9.8 per cent.

Clark says: “We have been running pretty hard to play catch up. The first quarter was a tough one for us as a number of poor quality constituents of the small cap index performed well. We had been worried about them at the tail end of 2011, but as we entered 2012 it became apparent that some of these were not, in fact, going to go bust. As a result their stock prices moved sharply and we were a bit left behind as we did not own any of them.”

Yearsley says selecting the right manager is even more important in the small cap space, given the volatility of the sector.

He says: “I think with the right manager and the right funds, small caps should provide longer, stronger growth than large caps. You expect them to outperform in the higher growth end of the market as they are more nimble.

“The thing about small caps is you have got to have a period where you offload risk in the market and small caps, especially micro caps, will get hammered in those periods. When there is an absence of risk appetite people go for more liquid large caps. I would say at the moment the market as a whole is a bit uncertain about whether it wants risk on or risk off. You have got to invest in small-cap long-term.”