Introduction
Figures from the Investment Association (IA) show in February 2015 the sector recorded net retail outflows of £166m, with only the North America and UK All Companies sectors recording worse figures.
The sector as a whole has also seen outflows in 10 of the past 12 months as a combination of lacklustre performance and increased demand for income has seen investors drawn towards equity income funds.
In spite of the seeming recovery in the UK economy, not all small-cap investors are reaping the rewards, at least not in the short term. The past 12 months saw the IA UK Smaller Companies sector recording an average loss of 3.22 per cent in the period, according to FE Analytics.
However, Richard Penny, manager of the L&G UK Alpha fund, notes that for the past six decades the smallest 10 per cent of UK companies has outperformed the FTSE All-Share index by 3.5 per cent, while up until a year ago UK small caps was the best performing IA category over five years. According to FE Analytics, the average five-year return of the IA UK Smaller Companies sector to April 1 is 96.65 per cent.
But he adds: “During the past 12 months, UK small caps have experienced weaker performance, with investors hunting for yield and switching to large caps that are expected to be beneficiaries of European quantitative easing. UK small caps are currently attractive from a valuation perspective, trading at a discount to large and mid caps. [However,] we should see reasonable growth in the UK small cap sector this year.”
With an election only a month away, the uncertainty surrounding the potential outcome is one of the biggest challenges for UK smaller companies, with many of these stocks having a large exposure to the domestic economy.
Mr Penny suggests: “Investors in UK small caps should be looking for companies with good growth, pricing power, and those less impacted by cyclical rallies. There is a diverse investment universe of 1,500 companies to choose from in small caps, rather than the 350 larger companies. Therefore, it is important to be selective in where to invest.”
Like Mr Penny, Paul Marriage, co-manager of the Schroder UK Dynamic Smaller Companies fund, says there remains plenty of value in small caps compared to its mid- and large-cap peers, but notes an election is not an easy time to be in the stockmarket.
“We are 50-60 per cent exposed to the UK economy in our fund and if you look at our portfolio, small caps are cheap. There are lots of stocks trading at 10-11x earnings, [while] mid caps are trading at 13-14x and large caps are 15x, but if you take out oil and miners then large caps are 18-19x earnings. So where do you see value?
“No one really likes small caps at the moment and they don’t like the illiquidity you can get in small caps. [But] it does feel that once we get through the election risk, people will look at markets and say there is a lot of value in small caps. I think post-election, there is scope for quite a big catch up trade in small caps.”
THE PICKS
Henderson UK Smaller Companies
Managed by Neil Hermon, who also runs the closed-ended Henderson UK Smaller Companies Investment Trust, this £112.32m fund has the seemingly simple aim of providing capital growth by investing in UK smaller companies. Performance has been consistently strong, appearing in the top 10 funds in the IA UK Smaller Companies sector across one-, three-, five- and 10-year periods to April 1 2015. Its largest sector weighting is to industrials at 36.5 per cent of the portfolio.
Invesco Perpetual UK Smaller Companies Investment Trust
This £205.6m closed-ended offering aims to achieve long-term total return through investments in a “broad cross-section of small- to medium-sized” UK companies, while “the pursuit of income is of secondary importance”. Managed by Jonathan Brown, the trust has outperformed the sector average consistently across one, three and five years. Its 10-year total return of 254.74 per cent also significantly outperformed the AIC IT UK Smaller Companies sector average of 175.29 per cent to April 1 2015, according to FE Analytics.
EDITOR’S PICK
Fidelity UK Smaller Companies
Launched in February 2011 this £260m fund is managed by Jonathan Winton and Alex Wright. According to the fund factsheet the managers focus on “cheap, unloved stocks with an asset or characteristic that gives the share price a margin of safety”. It also has the ability to use derivatives, with the fund having roughly 93 long positions and nine shorts at the end of February. Performance has been consistent, ranking it in the top five funds in the IA UK Smaller Companies sector across one and three years and topping the list across five years to April 1 2015 with a return of 177.68 per cent. Its largest sector weighting is to industrials at 30 per cent of the portfolio.
