Small caps spotlight: Are you missing out?

As the UK slowly emerges from recession, Joanna Faith finds out whether small caps are fair game once more...

Small cap stocks unsurprisingly took a battering in 2008 as risk appetite plummeted and liquidity constraints sent investors running to the supposedly safe arms of large caps.

However, since the UK officially exited recession in January 2010, the FTSE Small Cap index has made a sterling recovery, returning 42% to the end of May 2011 versus the FTSE 100’s 26%.

The outperformance of smaller companies is not surprising as historically they tend to perform most strongly coming out of recessionary periods.

Peter Ewins, manager of the £252.1m F&C Global Smaller Companies fund, says: “As investors become more confident in the outlook, they are more prepared to look further down the market capitalisation list for better recovery plays.”

Meanwhile, Gervais Williams, managing director of MAM Funds, says the opportunities for decent growth in dividend income are much greater in smaller businesses.

M&A boost

But another important factor is driving interest in the space – the chance of a boost in M&A activity over the next couple of years.

Simon Evan-Cook, investment manager on the multi-asset team at Premier, says people like to have a reason to buy into a sector and possible M&A action is a good one.

“Large companies will be looking to buy growth by bolting on smaller companies and this will be a boost to the sector,” he says.

Yet even despite the M&A story, Evan-Cook is bullish on small caps, so much so he says there is an argument to have a permanent allocation to the asset class, despite its inherent volatility.

“Over the long term, small cap performance has been outstanding and the alpha generation potential is superb.

“It’s one sector where it’s hard to hug the benchmark and where managers are forced to be active.”

Premier has a 6%-7% allocation to small caps in its growth fund via the £215.5m Aberforth Smaller Companies fund and the £55.5m Cazenove UK Smaller Companies fund, run by Paul Marriage.

He says the former has a more value approach, while the latter seeks out companies with a higher growth profile, but both are based on a bottom-up, stockpicking style of finding good quality companies.

Premier also holds the £32m Chelverton UK Equity Income fund, which invests in small and mid cap equities.

Evan-Cook says: “We like it because of its income mandate but also because it gives us access to part of the market you don’t typically get from other equity income funds. It also naturally steers us away from banks.”

Small and nimble

Meanwhile, Stephen Peters, analyst at Charles Stanley, also likes small caps primarily because it is an under-researched sector with some very good managers.
Although he says some funds in the sector are big, which means sector liquidity can be poor, he likes the open-ended vehicles run by BlackRock, Cazenove and Old Mutual.

“We like Cazenove’s fund because it’s small and nimble, with a quality and value tilt,” Peters says.

“BlackRock is one of the best teams in the city for small caps, with a punchy, mainly growth, but reasonably flexible style, while Old Mutual has a strong team, a great long term track record and a pragmatic proven approach.”

In the closed-ended space he rates the long term track record of Aberforth, although he highlights its recent disappointing performance; Invesco’s UK Small Cap trust which he says is cheap on a discount basis; and the smaller and more nimble Montanaro UK Smaller Companies trust, because of its great individual stock analysis and strong recent track record.