Bouncing back: Why we shouldn't write-off small caps just yet

Top UK Smaller Companies managers tell Maria Merricks why they are positive the sector can bounce back from a difficult period.

This summer’s market volatility left UK Smaller Companies fund managers with a challenging backdrop. With investor outflows of £34m in August, the sector was the seventh worst selling of the IMA’s 32 overall, according to the Association.

But if the market turmoil of 2008 was anything to go by, managers should not have been surprised. UK Smaller Companies was one of the biggest casualties of the recession as panicked investors fled from the riskier end of the equity spectrum into more liquid asset classes.

The IMA’s classification stipulates funds in the sector must invest at least 80% of their assets in UK equities of companies which form the bottom 10% by market capitalisation.

Better than 2008

Despite the outflows, managers are confident the sector has held up well compared to 2008. Robin West and Tony Belsom, co-managers of Aviva Investors’ UK Smaller Companies fund, put its “relative resilience” down to three main factors.

First off, the composition of the FTSE 100 versus the FTSE Small Cap indices has held the latter in favour. In the downturn of the past few months, the banks and the miners have been hit hardest. The FTSE 100 has a heavy weighting to these sectors, while the FTSE Small Cap is notably underexposed.

Meanwhile, investors in the small cap universe this time around are largely made up of the more traditional long-term investors the sector is suited for, rather than the likes of the multi-cap, hedge fund mangers that were present in 2008.

“At the end of a bull run you tend to see these sorts of managers dipping further down the market-cap spectrum and then, when things start to turn, they are the first to panic. Undoubtedly, this caused an impact in 2008 but they have not really come back into the sector since then,” says West.

The final point is the strength of the underlying companies. West is seeing more caution, lower levels of debt and stronger balance sheets.

As Anthony Cross, manager of the Liontrust UK Smaller Companies fund, puts it: there has been quite a lot of sorting out.

“Although we do not know at this stage if we are going to have another downturn, I am not expecting it to be as dramatic for companies as it was back then. Certainly not as frightening,” he says.

Long-term outperformance

With this in mind, managers in the space are keen to highlight the well-versed case for the sector’s long-term outperformance. It seems for the long term investor, UK Smaller Companies should not be overlooked.

Harry Nimmo, manager of the Standard Life Investments UK Smaller Companies fund, says there are a number of compelling factors driving these trends.

Perhaps the most obvious point is the scope for smaller companies to grow as opposed to their larger counterparts. For example, how many large caps have the potential to double in size the way many smaller businesses do?

Meanwhile, and particularly relevant in the recent market conditions, is the fact smaller companies have a lower correlation to global growth trends.