Q&A: Small and mid cap stocks

Old Mutual’s Dan Nickols, discusses his outlook for mid and small caps and what 2011 holds for UK markets.

Dan Nickols, manager of the Old Mutual UK Select Small Companies fund has concentrated his portfolio on stocks with global exposure or which are in secular growth trends and is selectively buying into businesses with a higher weighting to the UK consumer and government spending.

He explains his reasoning behind this strategy and why he sees UK mid and small caps as reasonably valued.

Q. The UK market has been pretty range bound this year. What is likely to change that?
A. It has been a frustrating year. We saw optimism in the early parts of the year leading to markets reaching a peak in April of this year, and it has taken until October for markets to regain that peak. But, looking forward, while clearly there are risks and issues to worry about, in the round I would tend to a more positive view.

I think on a three- to six-month horizon there are a range of reasons why the market can break through the highs that we have recently seen.

The simplest argument for that is if we look at the bigger picture, it still looks fairly clear that the world is going to grow at a rate of something like 4% next year.
If we look at the UK equity market, the indices are trading on about 11 times with earnings growth in the early teens, and the amalgam of those relationships tells me that if markets do not look particularly demandingly valued, growth comes through, then as and when that becomes apparent to investors, I would expect markets to respond and get better.

Q. So valuations on mid and small caps look quite attractive right now?
A. They are no longer the steal they were 18 or so months ago. But if we look at valuations, the All-Share is trading on around 10.5-11 times. Mid and small caps are trading at something of a premium, so around half to a full point P/E premium to the All-Share.

But again, if we look at the growth that I would expect to come through in terms of earnings growth over the course of the forthcoming year, I think we can realistically look for earnings growth in the mid teens going forward, and that being the case I do not think mid and small caps look particularly demandingly valued.

Q. Do you think cyclicals will maintain leadership over the next 12 months?
A. Again it is maybe worth taking a step back and considering where the index leadership is coming from in our particular space over the course of 2010 because it has been an intriguing year.

We have had a tug of war going on between those who believe we are heading for a huge recession and those who take a more optimistic view, and within that I think it is actually two distinct types of stock that have led the market over the course of 2010.

So, on the one hand you have had an array of structural growth companies, which have performed generally very strongly and which have achieved without necessarily delivering significant upgrades to forecast and have actually benefited from a significant upwards P/E rerating over the course of the year.

And on the other hand, we have had another basket of stocks, the more overtly economically sensitive stocks, which have typically delivered quite significant upgrades to forecast over the course of this year and have performed well as a result but have not necessarily enjoyed a material re-rating.

These two baskets of stocks have performed well.

Q. And what about the future?
A. I expect this sort of phenomenon to continue broadly, if only because of the element of stocks that have been left behind. In this case it is UK domestic stocks exposed to the UK government and to the UK consumer that have been left behind.

I do not see why, certainly on the sort of near-term view, investors particularly come back to that basket of stocks. So almost by default those areas or those types of stocks which have led the market thus far over the course of 2010 I expect to see outperforming.

Q. So how is your portfolio positioned today and for the next six months?
A. Our activity over the course of the last six months has been largely stock specific. The key themes we have in place are the desire to be exposed to higher quality, globally oriented cyclicals, along with a range of secular growth stocks. We maintained those themes over the course of the past six months or so. The activity that we have seen has been largely stock driven, and looking forward I would expect those themes to largely remain in place.

At the margin, in the context of being significantly underweight the UK consumer still, we are very selectively looking for cheap stocks where we think there is real solidity to the earnings forecast. That is just to give ourselves a little bit of protection against a scenario where the UK economy turns out to surprise mildly on the upside and investors tend back towards those stocks that have been left behind, but at this stage that is more of a marginal part of our activity.

Q. So you are a cautious optimist then?
A. In the round, yes. The global economy looks like it will grow at a reasonable rate next year. The UK economy is probably not quite as bad as is generally perceived, and for all of those reasons, combined with market valuation, I would tend to a cautiously optimistic view.