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.
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.
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
All investment returns are measured against a benchmark to represent “the market” and an investment that performs better than the benchmark is said to have outperformed the market. An active managed fund will seek to outperform a relevant index through superior selection of investments (unlike a tracker fund which can never outperform the market). Outperform is also an investment analyst’s recommendation, meaning that a specific share is expected to perform better than its peers in the market.
A catch-all phrase that can range from assessing the price of a property or vehicle before offering it for sale or the net worth of assets in an investment portfolio to the prices of shares on a stock exchange.
The familiar name given to securities issued by the British government and issued to raise money to bridge the gap between what the government spends and what it earns in tax revenue. Back in 1997, the entire stock of outstanding gilts was £275bn; by October 2010 it had surpassed £1,000bn. Gilts are issued throughout the year by the Debt Management Office and are essentially investment bonds backed by HM Treasury & Customs and considered a very safe investment because the British government has never defaulted on its debts and this security is reflected in the UK’s AAA-rating for its debt. Gilts work in a similar way to bonds and are another variant on fixed-income securities.
A collective investment vehicle (known in the US as a “mutual” or “pooled” fund) and similar to an Oeic and investment trust in that it manages financial securities on behalf of small investors who, by investing, pool their resources giving combined benefits of diversification and economies of scale. Investors buy “units” in the fund that have a proportional exposure to all the assets in the fund, and are bought and sold from the fund manager. The price of units is determined by the value of the assets in the fund and will rise or fall in line with the value of those assets. Like Oeics (but unlike investment trusts) unit trusts and are “open ended” funds, meaning that the size of each fund can vary according to supply and demand of the units form investors. Unit trusts have two prices; the higher “offer” price you pay to invest and the “bid” price, which is the lower price you receive when you sell. The difference between the two prices is commonly known as the bid/offer spread.
Investors who borrow money they use for investment and use the securities they buy as collateral for the loan are said to be “gearing up” the portfolio (in the US, gearing is referred to as “leveraging”) and widely used by investment trusts. The greater the gearing as a proportion of the overall portfolio, the greater the potential for profit or loss. If markets rise in value, the investor can pay back the loan and retain the profit but if markets fall, the investor may not be able to cover the borrowing and interest costs, and will make a loss. Also used to describe the ratio of a company’s borrowing in relation to its market capitalisation and the gearing ratio measures the extent to which a company is funded by debt. A company with high gearing is more vulnerable to downturns in the business cycle because the company must continue to service its debt regardless of how bad sales are.
An interchangeable term for shares (UK) or stocks (US). Holders of equity shares in a company are entitled to the earnings and assets of a company after all the prior charges and demands on the company’s capital (chiefly its debts and liabilities) have been settled. To have equity in any asset is to own a piece of it, so holders of shares in a company effectively own a piece proportionate to the number of shares they hold. (See also Shares).
A market-weighted index of the 100 biggest companies by market capitalisation listed on the London Stock Exchange. It is often referred to as “The Footsie”. The index began on 3 January 1984 with a base level of 1000; the highest value reached to date is 6950.6, on 30 December 1999. The index is “weighted” by how the movements of each of the 100 constituents affect the index, so larger companies make more of a difference to the index than smaller ones. To ensure it is a true and accurate representation of the most highly capitalised companies in the UK, just like football’s Premier League, every three months the FTSE 100 “relegates” the bottom three companies in the 100 whose market capitalisation has fallen and “promotes” to the index the three companies whose market capitalisation has grown sufficiently to warrant inclusion. Around 80% of the companies listed on the London Stock Exchange are included in the FTSE 100.
An individual employed by an institution to manage an investment fund (unit trust, investment trust, pension fund or hedge fund) to meet pre-determined objectives (usually to generate capital growth or maximise income) in prescribed geographic areas or investment sectors (such as UK smaller companies, technology or commodities). The manager also carries the responsibility for general fund supervision, as well as monitoring the daily trading activity and also developing investment strategies to manage the risk profile of the fund.
This refers to a market situation in which the prices of securities are falling and widespread pessimism causes the negative sentiment to be self-perpetuating. As investors anticipate losses in a bear market and selling continues, pessimism grows. A bear market should not be confused with a correction, which is a short-term trend of less than two months. A bear market is the opposite of a bull market.