Smaller companies boost for investors

The economy may be faltering and investors growing more gloomy, but small companies are holding their own.

After a dramatic recovery, which saw the stockmarket tiddlers trounce the giants of the FTSE 100 in mid 2009, the two indices have risen and fallen, more or less in tandem.

Small company funds have had a reasonable year: the average unit trust in the sector is showing a gain of around 5% over the past six months, rising to 17% over a year – comfortably ahead of the 0.9% and 8.8% gains of the more broadly based UK all companies funds sector.

Investment trusts have done even better, on a share price basis, reflecting their generally lower costs and ability to ramp up positive returns through gearing.

Over the past decade, the differences are even more marked. Small company investment trusts and funds are both up more than a third, while the average UK all companies fund has gained just 13.5%.

The key question is, can that continue? Over the long term, small companies should have greater growth potential than larger ones.

Over shorter periods, however, the returns from investing in them will be influenced by factors such as the economic outlook, investor confidence, interest rates and bid activity.

The first two factors are not currently looking favourable, although the second two could have a more positive impact.

Economic outlook

On the economic outlook, David Clark, manager of the Ignis Smaller Companies fund, is one of the more pessimistic – albeit that his fears extend to the market as a whole, rather than small companies in isolation. He thinks equities are heading for a bear market.

"I expect small companies to participate in that. Economic statistics have been awful and are likely to get worse, both here and in the US, so equities will fall.

But Clark does see some reason to be cheerful. Small companies tend to be more cyclically sensitive than large ones so, while they suffer more as the economy slumps, they should rebound more strongly as it recovers.

They are also more likely to be the target of merger and acquisition activity – something which Clark, like most of the other small company fund managers canvassed by Money Observer, thinks is likely to increase.

 The signs are already there: Richard Wilmot, manager of Newton UK Smaller Companies, says he is seeing bids almost weekly. "They are going to be a very strong characteristic over the next year to 18 months."

He cites three reasons for this. First, interest rates are low and are likely to stay that way. "That means keeping cash on the balance sheet generates no return."

Second, chief executives are motivated to go down the acquisition trail. "Generating growth is tough, so management teams will try to buy earnings growth."

And third, company valuations and financing costs are at a level where it is possible to make an acquisition and still generate an adequate return.

Spotting bid targets is not straightforward and Wilmot does not deliberately seek them out.

But the kind of analysis he employs in considering where to invest – looking for companies with a good financial position, strong management and the ability to grow – is similar to that used by firms screening for bid targets. That means his fund often ends up owning bid targets, as it did with Chloride.

He also says the current environment favours those fund managers who are genuine stockpickers. There is economic growth but it is moderate. Deleveraging, whether by banks or at a national level, will act as a drag on economic growth.

"It will not be roaring growth but there is a pulse. Small companies should be a buy. But it is all about picking the stocks that will weather tricky times."
Richard Plackett, manager of the BlackRock UK Smaller Companies fund, says the stocks that will outperform in the months ahead are different to those that have done well over the last year.

Growth areas

Surprisingly, given the much-reported death of UK manufacturing, many of these can be found in the industrial sector – Plackett cites companies such as engineering businesses Aveva, Spirax Sarco and valve maker Rotork.

Neil Hermon, manager of Henderson UK Smaller Companies, is also searching for overseas earners – he estimates that around half the turnover in his portfolio comes from overseas, which he believes to be greater than that represented by the small-cap indices.

Perhaps this is why he thinks the small-cap sector is in reasonable health, despite the economic gloom.

"Corporate earnings are very robust – there has been good growth, especially among small and medium-sized firms which positioned themselves well during the recession."
The small-cap indices currently trade on similar valuation multiples to large-cap indices, such as the FTSE 100.

Some argue they should be at a discount, reflecting the greater risk that things will go wrong; others that they deserve a premium because of their superior growth prospects.

Hermon says that equities, in general, look good value against other assets, such as bonds – and particularly gilts, where yields are extremely low – and property, where the recovery seems to be faltering.

Harry Nimmo's Standard Life UK Smaller Companies fund has grown 20% this year. He is optimistic that the companies in his portfolio will continue to prosper.

He adopts a 'buy and hold' strategy of running with the winners and selling losers. "My turnover has been only 25% this year but sometimes activity is a bad thing. You don't have to do much if you invest in good companies."

However, investors must monitor their portfolios closely. Small companies are risky: minor changes in circumstances can have a big impact on the business; and accounting and management structures can be less robust than at larger companies, so thorough research is essential.

This has become clear recently in some public sector businesses – disproportionately represented in the small-cap sector.

Their dependence on government spending had made them seem a safe bet as public spending was seen as immune to recession.

The government's austerity package has changed that: many firms in the sector predict plummeting demand as local authorities and government departments search for the 25% cuts demanded by the chancellor.

Care is needed when choosing funds. Ryan Hughes, senior fund manager at Skandia Investment Group, urges investors to note that the UK small-cap sector is very diverse and although many funds have similar names, they can have vastly different underlying holdings and levels of risk.

This article was originally published in Money Observer - Moneywise's sister publication - in October 2010