OMAM's Nickols reveals his five favourite small caps

Small caps valuations look ‘unrealistically low’ even after last year’s rally, according to OMAM’s Dan Nickols.

He accepts that at 12.5 times forward earnings, smaller companies are trading on a slight premium to the wider market, but he says this overlooks the earnings growth implicit in earnings forecasts, which will spark a further round of upgrades.

‘On the face of it they are on a bit of a premium but with earnings growth of only 8-9% implicit in the numbers, this is unrealistically low and analysts are still playing catch up, he says.

‘We have seen it time and time again. There is a definite trend of forecast upgrades coming through, which is not a surprise as there are a lot of internationally focused businesses with significant earnings potential.’

Nickols believes the market is moving away from the ‘dash to trash’, which saw the top down themes of cyclicality and indebtedness drive returns.

This has prompted him to balance out some of the cyclicality in his Old Mutual UK Select Smaller Companies fund with a number of secular structural growth names.

His key overweights include a focus on stocks with significant international exposure. Although small caps are traditionally seen as more domestic-focused in nature, Nickols says he is still able to pick up global leaders in their field- a fact overlooked by many investors.

‘Around 70% of the FTSE 100’s earnings come from overseas, but I have a universe of 600-700 stocks, which on average derive 40% of their earnings internationally,’ he says. ‘Our holdings generate around 60% of their earnings overseas and our key overweights include technology where we are able to build greater exposure than UK large cap managers and many of these are global leaders in their niche markets.’

The flipside of this focus on internationally-biased firms is an underweight in UK consumer-facing stocks, such as general retailers. He admits to being slightly nervous on this position, so has been reducing the position in case the Conservatives win the general election decisively, which would could boost consumer confidence due to the perception that they would be good for the economy.

However, he is maintaining his large overweights in construction and support services, both of which are heavily reliant on government spending and so in turn are not sensitive to the election given all party’s commitment to reduce the deficit.