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Small v large caps: where these five readers see best opportunity

In a new weekly feature we ask five wealth managers to answer a topic of the week. In our first serving we find out whether they think there's better value to be found in mid/small or large caps.  

James Butterfill, head of global equity strategy, Coutts

We believe access to lending, an improving economy and improving corporate confidence are the three key pillars for small cap outperformance.

Credit availability to the corporate sector, according to Bank of England data, highlights it is the highest it has been pre-European crisis in mid-2010. While we see the UK economy improving in 2014, the links between the FTSE 100 and a recovering UK economy are limited, with only 20% of revenues coming from domestic sources.

Smaller businesses in the UK derive 60% of their revenues directly from the UK and are therefore much more exposed to the domestic recovery. Corporate confidence data from the CBI highlights one of the strongest measures since records began in 1975 and the latest PMI data is currently the highest in the developed world, which is reflected in the strong small cap revenue growth.

While smaller businesses on a relative basis are more expensive than large caps, we believe they should continue to outperform. As the UK economy gathers pace it is likely that investors will be willing to continue to pay a premium for growth.

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Tristan de Gabiole, portfolio manager, Tier One Capital

I think smaller companies will generally perform better than larger ones in a bullish environment and underperform in a bearish environment.

However, I believe the FTSE 250 will at some point suffer from the lack of support for small and medium-sized companies since the onset of the credit crunch creating a shortage of growing companies now. In effect, there’s a black hole coming that will have an unknown effect. At the same time, the larger companies are still looking to put capital to work that will perhaps counterbalance this for the existing 250 companies.

It is true that most of the FTSE 250 companies are very expensive compared to the 100 largest stocks in terms of price-to-earnings ratios (22.88 against 12.72 respectively), but the universe is also 2.5 times larger in the mid caps. I think you can still find some very good opportunities; you just need to know where to look.

The key question would be more what sector to pick rather than the size of the company. Companies from the natural resources sector have been hammered over the last two years due to a decline in commodity prices coupled with an increase in the cost of production. I can see some high potential growth in this sector within mid cap companies.

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James Hedley, investment director, Rathbones

Last year saw the market rise on multiple expansion, as P/Es have risen: so companies need to be able to justify this by increasing earnings. This year has shown how the market reacts when this does not occur: with Rolls-Royce, WPP and Pearson, for example, all seeing sharp corrections when announcing weak figures.

Among mid caps, strong businesses are benefiting from survivor bias, and able to increase earnings. 2014 is going to favour active stock pickers far more than 2013, when ‘a rising tide lifted all boats’.

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Hector Kilpatrick, chief investment officer, Cornelian Asset Management

The 10 largest FTSE 100 Index constituents account for more than 40% of the index. To generalise, these stocks can be described, broadly, as mega cap oil, emerging market sensitives and pharmaceuticals.

While the management teams at mega cap oil are beginning to understand the importance of shrinking to enable a new dynamism, this process is likely to be long drawn out and is unlikely to ignite market participants’ excitement any time soon. And the emerging market sensitives are likely to continue to struggle while the Chinese credit bubble is reined in. This leaves the pharmaceutical sector, which is exhibiting value.

In aggregate, however, the outlook for these mega cap stocks is unlikely to excite in a manner that their smaller brethren can, particularly those that are more directly exposed to the resurgent developed market economies.

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Simon Nicholas, multi manager, Brown Shipley

I think the valuation starting point for UK mid caps now implies a lower return over the next few years than might ordinarily be expected from investing in this part of the market. The positive aspect of mid cap is a greater domestic orientation and the possibility of a pick-up in M&A activity.

My impression is there is more potential in smaller cap than mid cap (from a valuation perspective) based on the funds I follow. The FTSE 100, like most major developed markets (excluding Japan), rose last year based mostly on multiple expansion, so earnings need to come through in order for stock prices to progress further in aggregate.

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