Hermes managers John Leahy and David Stormont argue the next phase of a rally must be driven by a growth in company earnings.
“Small and mid caps have done incredibly well in the past year or so, however, earnings per share forecasts have barely gotten out of first gear. The performance of the market has come from a p/e expansion,” the managers of the Hermes UK Small & Mid Cap Companies fund explain.
“The question now is: ‘has the market gone too far’? We feel that some share prices are reflecting boom economic conditions whereas the economic recovery is likely to be more muted. The onus is now on earnings growth to come through in order to deliver further returns.”
Stefan Scheurer, senior capital markets analyst at Allianz Global Investors, points to two factors for performance of small caps. “On the one hand, many small caps are still in a growth stage. This results in a greater increase in profits and share prices. Investors are thus rewarded for the greater risk inherent in small caps,” he says.
“On the other hand, however, during crises and periods of heightened risk aversion, as investors flee, small caps underperform large caps. One reason for this is the lower liquidity of small caps because of their lower market capitalisations. That is what we saw when Lehman collapsed and during the eurozone government debt crisis.”
The FTSE AIM index, however, has not performed as well. In fact, it has lagged the FTSE All-Share index by almost four percentage points in the past 12 months to November 20.
Jonathan Gain, chief executive at Stellar Asset Management, says: “Many AIM companies have tremendous potential but also greater volatility than, for instance, the FTSE 100. Specialist expertise is therefore ideally required to find the stocks with the most attractive risk/return characteristics.”
Richard Power, head of the smaller companies team at Octopus, agrees: “The AIM includes a number of the most dynamic smaller companies in the UK. Compared with larger FTSE companies, which are covered by many analysts and attract greater investor attention, smaller companies can offer significant value and potential for earnings growth through careful stockpicking.”
Since August, AIM shares have been allowed in an Isa and, together with the income and capital gains tax exemption of an Isa, investors can reduce the value of their potential IHT liabilities while also seeking capital growth.
“AIM shares are now one of the most tax-advantaged of all investments since the majority of them benefit from Business Relief or Business Property Relief. This means that qualifying shares are IHT-exempt once they have been held for two years. Importantly, it also leaves investors with access to income and capital should they need it in the future,” Mr Gain adds.
Jenny Lowe is features editor at Investment Adviser