Argument for growth among smaller caps

It was the mid-to-small companies that bore the brunt of the European Union referendum results for example.

But Danny Cox, chartered financial planner at Hargreaves Lansdown, recommends that, unless they are totally risk averse, clients have a small amount of exposure to small caps.

He says a balanced portfolio will have exposure to a variety of sectors, which includes smaller caps.

Investing in the shares of small companies offers a risk return profile vastly different to that of medium and large sized companies.

He says: “These smaller companies tend not to pay so much income, so may not be suitable for some investors. They do tend to be more volatile, but can also be the most lucrative over time compared to large caps.”

Small cap stocks are prized for their attractive growth prospects.

Unlike mid-sized companies and large caps, small caps have the potential to grow and because of their relatively small size, an ability to innovate.

Yet small caps have been out of favour in the last few years, even prior to Brexit.

Richard Bullas, vice president, portfolio manager for the UK equity team at Franklin Local Asset Management, says the small cap bull market that began in the early summer of 2012 had largely run its course by mid-2014.

In the last couple of years relative performance has been more muted, with 2016 a particularly difficult year for smaller companies.

He claims this represents an opportunity for investors.

“This recent relative underperformance against the broader market means that an attractive valuation gap has opened up.”

Mr Bullas says UK smaller companies are typically trading on a 15 per cent to 20 per cent valuation discount to their larger peers and that the valuation gap can be explained by a number of factors, “the most obvious of which are the liquidity premium for larger companies and the greater domestic content in small cap earnings at a time of heightened uncertainty regarding the UK economy.”

“Given the decision to leave the EU, the UK is likely to experience an economic slowdown in 2017, though it will once again be the most dynamic of the major economies in 2016, with GDP growth of close to 2 per cent.

“We believe growth will be in the range of 1 per cent to 1.5 per cent – ‘slower’ growth, not ‘no growth’, and certainly not a recession.”

But small caps have been on the front line of dramatic swings in sterling.

Most of their earnings are UK generated, so they would not benefit from the cheaper pound enjoyed by their larger counterparts that get 75 per cent of their earnings from abroad.

Smaller caps would also bear the brunt of a predicted slowdown, or even recession, in the UK because of their reliance on the home market.

Rising stars and falling angels

James Illsley, portfolio manager in the JP Morgan Asset Management European Equity Group, explains smaller companies fall into two categories - rising star or fallen angel.

He says: “A rising star is a company that is near the start of its journey. A company that is starting to realise its potential.”

A fallen angel is a company on its way down, perhaps even a former FTSE 100 constituent.

For the purposes of this guide Mr Illsley considers small caps to be those outside the FTSE 350.

He says: “The pros of small company investment are that for a smaller company it is easier to grow earnings from a smaller base. But a small company will often only make its earnings from one or perhaps a couple of products.”

If that product does well then the potential for earnings is huge, but also relying on one products which could later fall out favour, the company in question would then find itself in the fallen angel category.

The only way to spot a small company with potential is to research it thoroughly.

“This is when you have to discover the underappreciated and undervalued growth stocks,” says Mr Illsley.

“Once something becomes known and is out there then you’ve already lost the bargain.

“My rule is once the taxi driver knows about it then it is gone.”  “There are a lot of glamour stocks with eye-catching business ethos - such as cloud computing, but it is the companies that can monetise these ideas or have an idea that give the potential to monetise it.

“Within small caps we are led by stock selection because themes among small companies are so wide and diverse. You think about Apple versus Dell. One year one was a bargain, the next it was a rising star and now it is a fallen angel.”

Long-term prospects

Patrick Connolly, a certified financial planner at Chase de Vere, says over the longer-term smaller companies, which are often dynamic firms, should be expected to outperform larger companies, which might be at the consolidation stage of their development.

“However, smaller companies are more volatile than larger ones and tend to fall further and faster when markets go down and investors shun risk.”

He says: “The best approach for most investors is therefore is to invest in a combination of large companies, which can provide greater security and small companies, which have better long term growth potential but are likely to be more volatile.”

Chris Kinder, UK equities portfolio manager at Threadneedle Asset Management, says a key feature of smaller companies is to be able to invest in businesses with higher growth rates at lower valuations.

“Post the referendum there is a certain amount of market uncertainty but consumer and CFO confidence have picked up from the post-vote dip.

“UK companies are also now significantly cheaper for overseas acquirers; therefore we wouldn’t be surprised if mergers and acquisitions (M&A) becomes a theme.

“When investing in small caps the focus should be on the fundamental drivers for the business with a macro overlay.

“Once there is more certainty in the market we expect a broader range of investors are likely to focus on the fundamentals and look to allocate more capital to small cap assets.”

Driver of performance

Mr Bullas says confidence will be the main driver of small cap performance going into 2017.

He says: “From the perspective of a small cap investor it is important that growth is sufficient to give management teams the confidence to continue to develop their businesses.

“One of the prime attractions of the small cap asset class is the sheer breadth of opportunity from an investable universe of more than 1,000 stocks.”

However many small caps will flourish whatever the macro back drop.

Mr Bullas says: “The asset class will, however, be much more interesting and potentially more profitable for investors if business leaders are still making decisions, buying and selling businesses and moving forward with investment plans.

“This will only happen if confidence holds up.

“New listings can provide interesting investment opportunities and takeovers enable value to be realised.

“We see the new issue market becoming busier in 2017 after a hiatus in recent months and believe the relatively low valuation of small cap stocks may well herald a period of increased merger and acquisitions activity in the New Year.”

Mr Bullas says: “We are hopeful that we will see a return to net inflows in 2017 as asset allocators become more comfortable with the economic outlook and focus more attention on the valuation opportunity.

“Small cap investing has always involved a trade-off between greater risk and greater reward. This remains as true today as ever but we are optimistic that, following a somewhat difficult 2016, there are better times ahead.”