Predators poised to swoop on UK small caps

A wave of takeover activity is expected in the UK smaller companies sector as US and European companies spend their surplus cash on acquisitions, according to a new survey of UK small-cap fund managers – and many believe that the deals will lift small-cap share prices.

In a poll conducted by Standard & Poor’s, the fund research and rating agency, the managers said the weakness of sterling would offer overseas companies the chance to acquire their British rivals at a discount, and improve their positions in the market.

UK engineering groups are among the sectors most likely to see consolidation this year, according to the research. As a result, quality companies such as Rotork and Spirax Sarco are now among the favoured holdings of UK smaller companies funds.

Richard Smith, manager of Invesco Perpetual’s UK smaller companies fund, is also overweight in healthcare companies as he believes they will benefit from cost-cutting moves by the National Health Service – which is likely to result in more outsourcing of services after this year’s general election.

However, like many of his peers, Smith is avoiding support services companies – taking the view that a period of cuts in public sector spending could drag down their profits.

Europe’s small-cap sector also looks appealing, particularly for investors seeking growth stocks, according to Andrew Lynch, manager of Schroders European smaller companies fund.

Lynch argues that the historical reluctance of European companies to pay dividends makes it a market more suited to investing for growth.

“For many European companies, dividends are a new phenomenon, rather than something demanded by UK investors,” he says. “There are still probably more growth stocks to be found outside the UK.”

On average, European small-cap funds have delivered better returns than their UK small-cap equivalents, but the sector still tends to be overlooked by British investors, according to Tim Cockerill, head of research with the advisory firm Ashcourt Rowan.

“For many investors, asset allocation to Europe is on a broad-brush basis with little segregated allocation to smaller companies,” Cockerill explains.

“And yet, the same investors will allocate to UK smaller companies, so they really are missing a good opportunity,” he adds.

Only 14 European small-cap funds exist, but there are a great number of “under-researched” income and growth stocks to choose from on the continent, he argues. However, currency fluctuations do have to
be taken into account –
and Cockerill notes that
the recent strength of the euro against sterling has made the market more expensive for UK private investors.

Nick Williams, manager of Baring Asset Management’s Europe Select fund – which holds more than 100 stocks and has returned an impressive 105 per cent in the past five years – argues that “less stodgy European small-cap growth stocks are a better bet than their large-cap counterparts as they offer more organic profits growth on average.”

At the moment, Williams favours defensive sectors such as technology, healthcare and consumer staples, in case the economic recovery remains “slow and protracted”.

“You can find growth stocks, which provide a certain amount of insulation against potential shocks from the economy slowing down, trading at attractive valuations,” he says.

“A lot of larger companies are essentially quite boring. Sometimes they yield a lot but grow quite little.”

Schroders’ Lynch appears more willing to scour the wider European market for dividend yields and remains keen on utilities and tobacco stocks.

Two of his stock picks are Red Eléctrica, Spain’s version of National Grid, offering a 4 per cent yield, and Swedish Match, the tobacco group, which pays 3 per cent and also engages in share buy-backs.

BCB Asset Management, the Swiss private bank, which provides a 6.4 per cent dividend yield, is a another favoured holding.

Philip Dicken, manager of Threadneedle’s Pan European Smaller Companies fund, is equally bullish on small caps’ investment prospects this year.

After a long period of difficulty, European small caps rose 71 per cent in the past year, according to Morningstar. But over the past three years, the sector has lost 1 per cent.

“While the rally at the end of last year means that we have reached mid-cycle valuations levels, we believe there is still a great deal of opportunity,” Dicken says. “The stocks that led the small-cap index in 2009 are less likely to be favoured now and, instead, more well-rounded growth stocks will come to the fore and deliver long-term performance.”

Dicken also favours stocks that are poised to benefit from the rise of Asia and other emerging markets.

Vopak, the chemicals and oil storage products group, is one company that he highlights because of its history of profits upgrades. Dominos Pizza UK is another and IRL Software also ranks highly as an investment prospect.