Small and mid-caps seek to maintain momentum

But with these smaller companies having been on a charge since mid-2012, is their steam about to run out?

Between 1 June 2012 and 10 May 2014 the FTSE 100 delivered a decent return of 38.95 per cent in some volatile economic conditions. However, the FTSE 250 index, covering the mid-cap exposure, returned 61.59 per cent in the same period, and the best performer was the FTSE Small Cap (ex investment trusts) index with a return of 83.53 per cent, according to data from FE Analytics.

With the UK economy predicted to enjoy GDP growth of 2.9 per cent in 2014 according to the International Monetary Fund, some might suggest that small and mid-caps have reaped the benefits of the recovery and growth part of the cycle when they traditionally outperform their larger peers and that now might be the time to bank profits and move out of the sector.

Investor demand

No so, says Stuart Widdowson, fund manager at Strategy Equity Capital investment trust, who notes that over a medium-term history “the big driver of the market in small and mid-cap performance has been re-ratings”.

“From November 2011 to mid-February this year, both small and mid-cap equities had rerated quite significantly. We think that’s been driven by increased investor appetite in those asset classes.

“As particularly in small caps investors perceive small cap companies tend to be more domestically focused, and with the UK economy getting better the outlook for trading for small cap companies is also likely to be better.”

This appetite for UK small and mid-cap exposure is highlighted by the results of a recent survey by ICM on behalf of Octopus Investments, which revealed 83 per cent of financial advisers think investments in smaller companies can play a meaningful role in financial planning.

This follows further support from the government in the March Budget, in terms of continued tax breaks on Venture Capital Trusts and Enterprise Investment Schemes, which encourage investment into more niche smaller companies that are either unquoted or listed on the smaller UK indices.

Guy Myles, co-founder and managing director of Octopus, says: “It’s encouraging to see that so many advisers are becoming aware of the benefits of smaller company investing to support financial planning.

“Smaller companies can offer significant growth and income potential for investors over the long term. What’s more, it’s clear that many people really value the impact that the UK’s smaller companies have had on aiding our economic recovery in recent years, and many of our own investors welcome the opportunity to support the next generation of British businesses.

“It’s an exciting time for enterprise and smaller companies in the UK and the government continues to lend its support to this sector.”

Meanwhile the performance of both open-ended and closed-ended vehicles investing in UK smaller companies has seen the benefits of investing in the sector. The IMA UK Smaller Companies is ranked top of all IMA sectors across one, three and five years to 9 May 2014, while the AIC UK Smaller Companies sector is ranked top quartile and in the top 5 sectors across one, three, five and 10 year periods, according to FE Analytics

Mr Widdowson relates this again to investor demand and notes that in terms of investor flows into UK small and mid-caps, there has been “a notable change in long term trends from 2011”.

He explains: “From 2002 to 2011 there were a lot of outflows from small-cap funds, those outflows then started to reverse from 2011 and they became significant inflows from mid-2012 onwards. Investor appetite is improving combined with investor inflows means it becomes a bit of a self-fulfilling prophecy.”

Mispricing

However, he points out that in 2014 there have been a high number of profit warnings across the stockmarket and across all market caps, which has led to some unexpected disappointments and reduced earnings growth forecasts across the spectrum.

Mr Widdowson adds: “The markets have brushed this off in our opininon, perceiving that 2015 will be better than has previously been expected. Markets look nine to 18 months forward so the market has taken all this in its stride.

“In the short to medium-term our view is that one has to be quite selective by investing in the market at this point in the cycle. With all the money flowing into the sector, it is unlikely that all the capital has been deployed in the most efficient way, so we think that has led to mispricing in the market.”

While mispricing typically suggests opportunities, it also means that some stocks can be overvalued, with the manager using the analogy that as all boats have risen with the tide “now we’ll see which are seaworthy and which have a leak in them”.

Looking ahead the manager suggests that the big differential between the winners and losers in this part of the market will be based on investing in companies that not only deliver but that also exceed expectations.

“Smaller companies – those with a market cap of less than £500m – are still very under-researched, and if you’re a fundamental investor and do the work you can find some quite mispriced situations that are either under-researched or less well understood by the market. We think that’s particularly the case at the moment,” explains Mr Widdowson.

“Also with all this money coming into the sector, there is a very narrow differential between the valuation of good businesses and less good businesses. We’d expect that to reverse and for good businesses to go a significant premium. So we think high quality businesses are starting to rerate.”

While small and mid-caps have performed exceptionally well, the key thing is to know what you or your small cap manager is invested in, if future performance is to continue in the same vein.

One of the benefits of the mid and small cap universe is the much wider range of companies to choose from compared to a large cap focused investor, so as we move into a potentially more stable economic environment the asset allocation and underlying companies become even more important.