UK smaller companies have underperformed recently but hold out promise for the long term.
Small caps did well in last year’s rally, but have underperformed in 2014, because investors have shied away from risk.
Small caps suffered worse than large caps in the recent sell-off. Since the start of the year, the FTSE Small Cap (ex investment trusts) index has fallen 8.5%, while the FTSE 100 is down less than half of that, 3.7%. The Alternative Investment Market (AIM) index has performed particularly poorly, falling 18.3% this year.
Small caps tend to underperform in downturns and outperform in bull markets. Over the past few months, investors have clung to safer large caps.
This sell-off, though, has increased small caps’ value metrics, taking some of the froth off many, and risk-tolerant investors may be tempted in. Whether they are right to do so depends on whether the UK economy continues to grow, or whether it gets sucked into the stagnation spreading over Europe.
Fund managers who specialise in small caps need to take investment horizons of several years. Their liquidity risks alone require that. Small caps are for investors, not traders.
Small caps often have the potential to grow fast. They should benefit more from domestic economic growth. They have thinner defences than large caps in a downturn.
Ceramic filter specialist Porvair is a small firm with good growth. It is liked by AXA Investment Managers and by Chelverton Asset Management.
Illiquidity is a problem for funds dealing in small caps. A large cap, with high trading volumes, can be exited quickly, but a small cap with low liquidity can lock managers in.
Therefore small cap investors need to think long term, undertake serious scrutiny of companies before committing, and be prepared to hold for three to five years.
Small caps are more volatile and more prone to disasters. The AIM market is especially risky: it has been home to many flaky stocks.
Small caps are more expensive, because the market expects more earnings growth from them. Price earnings ratios can be double that of large caps.
‘Small caps were looking quite overvalued as we went into the spring,’ said James Baker, co-manager of the Chelverton UK Equity Growth Fund. ‘But now they look pretty attractive again.’
Online fashion retailer Asos was clearly overvalued last spring, since when its shares have fallen by a third.
Feel the width
Small caps are under-researched, which is a risk but also an opportunity for managers to add alpha.
Quality small caps should be cash generative and able to fund their own growth, rather than relying on heavy debt. They should have high profit margins based on competitive advantage. This is better than betting on a dream. Take a company like Monitise, which might be able to cash in on a revolution in payment by mobile phone; on the other hand, it might not.
Small caps led the recent market fall. This is a reversal of the trend for five years, over which the small cap index returned 61.7%, beating the FTSE 100’s 45.3%.
The question is whether the five year bull market has now ended, or whether it will bounce. Sentiment today is better than in 2011, during the eurozone crisis, when the correction was followed by a bounce in 2012. And most feel the fall will not be like the crash of 2008.
The German problem: DAX leads the retreat
Small caps are an area in which good managers can add alpha, but where there are many pitfalls. At present, they are out of favour with investors, but for those who like them, this is a buying opportunity. A few small caps will become the large caps of tomorrow.
HOW TO PLAY IT
Marriage had been the clear leader but has slipped over the past year.