Hot100 profile: Kames UK Smaller Companies

Elaine Morgan, manager of the Kames UK Smaller Companies fund, tells Cherry Reynard why her fund should be able to adapt to all market environments.

In the recent market rout, smaller companies have been spared the liquidity driven sell-offs that dogged them in the 2008 market crash. In fact, the smaller companies sector has held up better overall than the UK All Companies sector. In spite of this, Elaine Morgan, manager of the Kames UK Smaller Companies fund, believes that there is still value in the sector, which on a number of measures looks extremely cheap relative to history.

Morgan has run the fund since June 2006. The fund is up 42.7% over five years, compared to a sector average of 19.2%. This is in spite of a relatively weak last quarter, which has seen Morgan shift the overall positioning.

The fund is one of a number of funds fuelled from the Kames (formerly Aegon Asset Management) UK equity process. This uses three main types of analysis – fundamentals, valuations and technicals. The team believes that markets will value different approaches at different times: at some points in the market fundamental factors such as balance sheet strength will be very important, at others cheap valuations may be a driver for share prices. The team aims to assess the market cycle and weight the individual factors accordingly.

In this way the fund should in theory be able to adapt to all market environments. Morgan admits that it will tend to underperform at inflection points while the portfolio is adjusted to the new environment. Nevertheless, it has outperformed the wider sector in every discrete year since 2006, except for the soaring markets in 2009, and different things have contributed to that performance each year.

Morgan says: “In 2007, we were defensively positioned with some exposure to emerging markets growth. In 2008, we were out and out defensive, holding companies such as Amlin, Connaught and Chemring. In 2009, we were behind the index, but had a successful overweight position in consumer cyclicals. In 2010, we moved into structural growth areas. We held companies such as Hargreaves Lansdown, Domino Printing and Chloride.”

“In terms of the long term performance, it is all coming from stock selection, but each year has a difference theme. We aim to pick the right stocks for each different environment.”

Each part of the group’s analysis picks up on a different area. The ‘fundamentals’ part looks at detailed company analysis, analysing corporate strategy and financial strength. It will also look at the macroeconomic environment in which a company is operating to assess whether it has the potential to grow earnings.

The valuation assessment looks at the company’s valuation relative to history and its peers in the sector. The technical analysis looks at momentum factors such as earnings or price momentum. It will also look at directors dealing and whether a company has recently upgraded its earnings estimates.

The fund has had a difficult quarter. In the first half of the year, it was running well ahead of the Hoare Govett index, having held some in-favour international cyclical companies, combined with some strategic growth names. This was based on Morgan’s view that the capital expenditure cycle should continue to support earnings for many smaller companies. However, in July and August, this pro-earnings momentum stance hurt returns as risk aversion rose.

Morgan says: “We have tweaked the portfolio in response to the recent problems. We had been taking profits in some cyclical names that were geared to the level of production activity. We are continuing in this process. However, we have retained positions in companies that are exposed to improved capital expenditure by companies and where there is therefore strong visibility of earnings. The cyclical positioning has moderated.”

The recent falls have enabled Morgan to top up on some quality growth companies in the portfolio. These fell along with cyclicals, but the outlook is better. Morgan gives the example of Telecity, a data centre provider with operations across Europe.

Morgan believes that there is still value in smaller companies, in spite of their recent strength. She says: “There isn’t a significant difference in the valuations of smaller companies versus larger companies. In fact, if you look at the Shiller P/E, which adjusts for margin growth, it has only been lower once since 1985. The current yield on the All Share is around 4%, which has historically been a good level to buy into equities.”