UK investors are continuing to put their faith in small caps, undeterred by the sector’s 42 percentage point outperformance of blue-chip shares since the start of the year.
The FTSE Small Cap Index – which comprises companies outside the FTSE 350 index and represents approximately 2 per cent of the UK market capitalisation – has returned just over 50 per cent since the start of the year to date, compared with the 18 per cent return recorded by the FTSE 100. This represents a significant bounce following the near halving of the Small Cap Index in 2008, when the average small cap stock lost 44 per cent.
However, small cap investors continue to believe that valuation anomalies exist – with some claiming that certain smaller companies are trading on 20-30 per cent below fair value.
“The small cap market is probably more inefficient than it has ever has been,” says Marina Bond, a fund manager with Rathbones. She points out that brokers and fund managers deserted the sector after years of poor performance and poor liquidity. As a result, she believes there are still profitable trades to be made. “This represents a big opportunity for fund managers because people aren’t in touch with what’s going on.” Her fund’s holdings include engineering specialist Hyder Consulting, electronics company Volex and the TV set-top box maker Pace.
Other investors argue that weak economic conditions in the UK have forced the managements of smaller companies to cut costs aggressively and sell unprofitable assets – making the companies more efficient.
“Six months ago [small companies] had to go through cost cutting, being worried about survival,” says Giles Hargreave, a principal of Hargreave Hale, the small cap specialist manager. “They also destocked. So everyone got a lot leaner and meaner.”
His fund also owns Pace shares, which have more than tripled in the past six months. Other holdings include West China Cement (WCC) on the Alternative Investment Market (Aim), which has seen its shares rise equally quickly. WCC raised nearly £20m three ago to increase its production to satisfy new contracts.
“Cement in western China is clearly a good business,” says Hale. Even after its share price rise, WWC still trading on about 6 times forecast earnings, he notes.
In their search for sustainable gains, some investors are now focusing on UK-listed small caps with overseas earnings. Stuart Sharp, fund manager at Rensburg says that, for the first time in two years, he is bullish about small caps. The majority of his portfolio is in such “foreign” companies, and he is more optimistic about global growth, than domestic.
He is quick to point out, however, that each company he owns must have two members of its board based in the UK. “I’m spending more and more time travelling because, with these companies, management is everything. If something goes wrong, you don’t just lose 5 per cent, you can lose the whole lot,” he says.
Sharp is also positive on gold, because he sees inflation on the horizon and believes that the price of gold – a traditional hedge against inflation – will be a beneficiary of this. He has just returned from a three- day trip to Egypt to visit Centamin Egypt, the gold mining company which has seen its shares almost double in the past six months. Centamin is currently at the riskiest stage of its life, because it is in the mine commissioning phase. But Sharp says that his visit has reaffirmed his belief in the group, which now has a market capitalisation close to £1bn.
For stockpickers, though, the challenge is in finding shares that have further to rise than to fall. Cavendish fund manager Paul Mumford warns against excessive bullishness. “When I’ve had companies coming in to see me, they haven’t flung their hands up in the air claiming roses. They still talk of the market being challenging, but don’t have the doom and gloom of the first two quarters.”
