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UK small caps remain relatively attractive

    CPD
    Approx.0min

    Equity markets proved surprisingly resilient in 2012, considering the political and fiscal uncertainty in European economies, the growing spectre of the US fiscal cliff and evidence of economic growth slowing in China.

    This trend has been particularly true in the UK smaller companies space. In fact, the FTSE Small Cap ex-IT index has outperformed the FTSE All-Share index and most other international indices in 2012, with a return of just more than 22 per cent to November 29 2012.

    But do a couple of years’ strong performance from small companies mean that large caps should be a focus for 2013?

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    There is evidence that suggest that positive returns in 2012 mark the continuation of reasonable growth in UK small caps, and provide reasons why investors should consider this space.

    Firstly, the key FTSE Small Cap ex-IT index for UK small companies remains at a price-to-earnings discount compared with the FTSE All-Share, and at a discount compared with its 10 year average. This suggests that in spite of strong recent performance, small caps remain attractively valued relative to other UK equity sectors.

    Some argue that smaller companies will trade at a discount to larger companies because they tend to have lower exposure to emerging market growth, lower trading liquidity and face a higher cost of capital. However this discounts ebbs and flows, and as recently as 2007 small-cap indices traded at a price to earnings premium to the FTSE All-Share index. Over the long term, small companies have outperformed larger peers. For example, the Numis Small Companies index has outperformed the FTSE All-Share on a total return basis by 3 per cent a year since the beginning of the 1960s.

    Another interesting feature of small caps is that they demonstrate low levels of correlation to the FTSE All-Share and other indices. Bloomberg data shows that the FTSE Small Cap index has a correlation of 0.69 to the FTSE All-Share, and 0.64 to the S&P 500. This means that small-cap portfolios can offer an equities portfolio greater diversification, which many investors are looking for at a time when global markets remain volatile by historic standards.

    The small-cap universe also provides specialist investors with the chance to uncover opportunities that others may miss. There is a wealth of unloved, under researched and overlooked businesses at this end of the FTSE All-Share universe. On average, only two analysts research businesses that have a market capitalisation of between £25m and £100m, whereas you find 20 analysts following businesses that have a market capitalisation of more than £1bn.

    However, good quoted small businesses are unlikely to remain under valued for long periods. Currently the corporate sector has strong balance sheets and often access to cheap debt, providing management teams at larger businesses the ability to finance acquisitive growth. Once these teams feel more confident about economic growth, then discussions on using balance sheets for buybacks and dividends will move towards conversations about acquisitions to supplement low organic growth prospects.

    The recent acquisitions of UK small companies such as the hedge fund administrator GlobeOp, engineering specialist Hamworthy and engineering consultant WSP could be the start of a trend that will see a wealth of M&A in 2013, which will benefit investors in the right UK smaller companies.