28th January 2013
“Those that have survived this far are in a far stronger position than many of the larger companies,” says Darius McDermott from Chelsea Financial Services. “They have benefited from being specialist businesses that are still in demand, and they are ‘fat-free’ and run very tightly when it comes to cost.”
The potential of the sector was demonstrated in performance last year, as despite ongoing economic woes the IMA UK Smaller Companies sector topped the list, returning 22.61 per cent, with the IMA European Smaller companies returning 22.41 per cent.
Adrian Lowcock, senior investment adviser at Hargreaves Lansdown, says: “That smaller companies would do so well in 2012 was on few people’s picks as the global economy remained weak and growth elusive – particularly in the UK and Europe.
“However, the financial stimulus from the Bank of England and stronger conviction from Europe resulted in a much improved second half of the year with confidence returning.”
But will this sector’s tenacity be reflected in performance this year, with economic growth remaining anaemic and fears of a triple dip?
While investors have probably seen the best of the small cap rally from the market bottom in 2009, says McDermott, this section of the market is still not expensive and, as the economy recovers, smaller companies should continue to do reasonably well. I'd say there is further to go still,” he says.
Tim Hathaway, U.S. Smaller Companies co-fund Manager at Brown Advisory, stresses that mergers and acquisitions across the small-cap universe stand out as a key pillar of strength.
He says: “Large companies may possess rock solid, cash-rich balance sheets, near record profit margins and access to cheap credit, but what they lack is growth. Acquisition provides the potential to strategically capitalize on growth by opening up new markets and/or providing revenue and cost synergies.
“Although we never purchase a company with a ‘take-out’ thesis, we try to understand the value of a business within an M&A context as a potential downside-support mechanism. We focus on high-quality business models that have meaningful runways for long-term growth, and believe that such companies are compelling and deserving of long-term ownership, and as such many are attractive targets for strategic buyers as well.”
Long-investors should certainly profit, according to Patrick Connolly, certified financial planner at AWD Chase de Vere, who stresses that UK smaller companies have typically out-performed their larger brethren by around 3.5 per cent per annum. “Smaller companies are usually more dynamic and have greater growth potential than larger firms, which are often at the consolidation stage of their development,” he says. “Over most reasonable periods it is therefore likely that smaller companies will outperform larger companies.”
However, investment in this area is high-risk, and can suffer sharp downturns as a company goes through its most rapid growth stage – and of course, many will fall by the wayside. For example, in adverse market conditions such as 2008 stocks in this sector fell by over 40 per cent.
Connolly says: “The illiquid nature of smaller company stocks pushes prices down too much as investors seek security in more difficult times – but the bounce back can be swift when sentiment recovers as demonstrated by returns of over 50 per cent in 2009 and 30 per cent in 2010.”
Managers in this sector are also able to seek out the value in the sector to benefit from any upturn, stresses Lowcock. “This part of the market is often less well covered and researched than the large FTSE 100 companies, which means those fund managers who do their research are able to find investments opportunities which may have been missed by the wider market.
“Managers in this space tend to get involved with the businesses they are investing in, meeting the company’s managements. “
Turning to fund recommendations, McDermott and Lowcock tip Cazenove UK Smaller Companies, managed by Paul Marriage since 2006, which posted an impressive 36.7 per cent return last year.
Marriage has over 10 years experience managing smaller company assets, and has seen continued top performance from a diverse range of stocks, and adopts an entirely bottom-up process, investing in small cap stocks based on growth potential and value.
Connolly likes Investec UK Smaller Companies, Old Mutual UK Select Smaller Companies and BlackRock UK Special Situations, which has a significant weighting in smaller companies, while McDermott favours Marlborough Special Situations, which focuses on small and micro British companies.
He says: “Giles Hargreaves is one of the best UK smaller companies stock pickers around and this was the best fund of all UK funds in the noughties. It's well diversified to mitigate risk at the moment, investing in over 200 companies.”
The past decade has seen a shift in the outlook for smaller companies, with many making bumper profits outside of the UK as they are able to rely on international revenue streams. For example, the US has the world’s largest smaller and mid-sized companies markets.
Lowcock says: “The outlook for the US economy is improving. The country could become nearly energy self-sufficient by 2020, which has significant implications for the US manufacturing sector, making it more competitive, and smaller companies are likely to be at the forefront of any American industrial
He recommends Legg Mason US Smaller Companies and Standard Life Global Smaller Companies funds, with are able to tap into the opportunities across the pond.
Of course, if you are keen to target smaller companies with an international flavour, you can always invest directly, although this involves greater risk than a diversified fund.
The consensus is that for investors seeking security and liquidity this sector will present problems, but long-term as the UK and global economy recovers this sector has the right qualities to out-perform.