The ongoing winning streak for value and recovery stocks has led to another “deeply frustrating” year for the quality growth-focused Montanaro UK Smaller Companies investment trust, in spite of solid absolute returns.
In the 12 months to the end of March, the trust posted a share price growth of 16 per cent to reach an all-time high, but this was against a 23 per cent increase in the benchmark Numis Smaller Companies ex Investment Trusts index.
This reflects a broad-based revaluation of mid and smaller companies in most developed markets during the period, quadrupling the 5.2 per cent return from the FTSE All-Share index.
Stressing his long-term track record built on investing in high-quality companies that are growing, manager Charles Montanaro said the underperformance was disappointing but not surprising in an environment that has favoured higher-risk investment.
“Although UK smaller caps overall have seen solid performance, there has been a significant divergence in returns between the types of companies,” he said.
“[European Central Bank president] Mario Draghi’s speech in July 2012, promising to ‘do whatever it takes’ to defend the euro, combined with signs of economic recovery in the UK, significantly increased risk appetite.
“As a consequence, high-quality, global growth companies were sold to buy lower-quality, cyclical value stocks – a risk-on trade that has continued ever since.”
In spite of this, Mr Montanaro remains confident he holds a portfolio of companies that will generate sustainable and growing free cashflows.
“We believe such stocks will deliver substantial shareholder value for years to come, as they have in the past, irrespective of market trends, cycles or investor sentiment,” he said.
After two consecutive years of strong returns from UK small caps, largely as a result of multiple expansion, Mr Montanaro said earnings growth has to be delivered for share prices to continue rising.
“We remain confident in the ability of our companies to grow, as do the management teams in charge of them,” he added.
“After nearly two years of outperformance by low-quality, value companies, the relative premium investors are paying for quality growth has fallen substantially, and the trust is well positioned to benefit from a return in appetite for the highest-quality small caps.
“As investors increasingly focus on earnings growth, they are likely to turn to quality stocks that are more likely to deliver. We look forward to the next 12 months with confidence.”
Montanaro claims it exclusively focuses on profitable businesses, and believes it is worth paying more for a higher quality, more predictable company that can be valued with greater certainty.
“We like cash-generative stocks with high operating profit margins – an indicator they are providing goods or services of value to their clients – that are better able to withstand a downturn,” he added.
Can the small cap rally keep going – or are large caps a better bet?
A key feature across many stockmarkets – particularly those in developed economies – has been the strong rise driven by ‘multiple expansion’.
This means stocks have been rising more on sentiment than fundamentals, and Charles Montanaro has said further rises in company share prices will be dependent on earnings growth.
A quick look at the FTSE Small Cap ex Investment Trust index shows it has comfortably outperformed its larger counterparts the FTSE All-Share and FTSE 100 indices in five-, three- and one-year periods, according to data from FE Analytics.
But year to date, the stats tell a different story. The small-cap index has produced positive returns but is now lagging its sibling markets.
Some managers who invest across the market-cap spectrum in the UK have been switching into larger companies. Aviva Investors’ head of multi-asset Peter Fitzgerald recently said the rotation started in March in the UK, US and European markets.
“What you’ve seen is some of the managers with a larger, more defensive tilt in the UK with a bias to large-cap businesses [doing] better than those with a bias to small and mid caps,” he said.
Colin Morton, portfolio manager on the Franklin UK equity team, said consumer cyclical companies had struggled recently, and that these tended to be small or medium-sized businesses, with larger caps proving “more resilient”.
Mr Morton said large caps had also had a fillip thanks to oil stocks rebounding, as well as merger and acquisition fever in large pharmaceutical stocks.
But it seems those wanting to stick with large caps may now need to stock-pick more rather than ride the broad market rise.
