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Finding the small cap winners
By Fiona Hamilton
While the past 12 months have been dire for most investors, they have been horrendous for those who put their trust in smaller companies. As the chart below demonstrates, UK smaller companies have fallen far more steeply than the larger companies which dominate the FTSE All-Share index. And, the smaller the company, the worse it is likely to have fared, with the FTSE Small Cap index suffering more than the Hoare Govett Smaller
Company index, which takes in larger small cap companies.
What the chart also shows, however, is that UK smaller companies enjoyed a fabulously successful four years prior to this recent setback. Just as importantly, the chart also indicates that the average smaller company fund has outperformed both the Hoare Govett and the FTSE Small Cap indices over one, three and five years, and has achieved a much better five-year return than the FTSE All-Share. This is because the UK smaller companies sector is large and diverse, where good research really can produce superior returns. As a result, investors who backed the better smaller company fund managers have done well over the longer term, despite last year's setback.
Standard Life Investments UK Smaller Companies fund has topped the sector over one and three years. It has been managed by Harry Nimmo since 1997. He started 2008 feeling exceptionally cautious, but began to see some "compelling investment opportunities" emerging following the spring sell-off. Nimmo's investment approach emphasises "stability, risk aversion and growth independent of the economic climate". It is therefore well suited to the current uncertain environment. "I like companies with robust and repeatable business models, especially those with overseas earnings," he explains.
Nimmo attributes his success to a well-tested screening process and intense research and company meetings which offer scope for intuition and judgement. He likes to concentrate on his best ideas, so has only around 65 holdings in the fund. This means it may be slightly more volatile than a less concentrated fund and explains why its Lipper score for capital preservation (four out of five, with five being the best) is slightly lower than its score for consistency, which is five.
Invesco Perpetual UK Smaller Companies Equity fund is the other way around in that its capital preservation score is top notch (at five), whereas its consistent returns score is good rather than scintillating (at four out of five). Richard Smith has been in charge of the fund since 2002, and says that his preference for companies with earnings visibility, robust balance sheets, recurring revenues and a well-proven management team means he tends to be in the top quartile in falling or sideways markets, but only second quartile when markets are more gung ho.
"If a company is poor quality, I don't want to know, no matter how far its price has fallen," he says.
BlackRock's five-strong smaller company team is worried about consumer spending, and that the economic slowdown could be severe enough to force companies and even the UK government to trim their spending plans. "We expect the government to delay or cancel non-essential, non-contractual spending where it can," says team leader, Richard Plackett.
As a result of its views the team has been avoiding wide swathes of the smaller company market, in particular retailers, leisure and house builders.
More than half the companies held by BlackRock UK Smaller Companies fund are involved in exports, including companies in the software, engineering, and aerospace and defence sectors and many of them are doing well in emerging markets. Bids for Expro (oil services), Chloride (uninterruptible power supplies) and IBS Opensystems (IT services) all contributed to a 5% gain for the fund in the second quarter. It's a reminder that, when smaller company prices fall to bargain levels, they can attract interest from bidders.
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