Signals of a small cap recovery?

There is no doubt that the UK smaller companies sector has felt the full brunt of the credit crunch as UK small caps fell out of favour thanks to their low liquidity and high exposure to the UK recession. However, following the UK smaller company investment company sector rebounding 25 per cent over the last three months leading to 30 April, a few managers believe there is reason for optimism in the sector.

Harry Nimmo, manager of Standard Life UK Smaller Companies Trust, says he is "extremely positive" about the outlook for the sector. He believes UK small caps are at a turning point with the next five years likely to bring the best returns for some time.

While Mr Nimmo might have been wrong in predicting last year in Investors Chronicle that the market would turn on 1 December 2008, he is adamant that markets passed an inflection back in early March. "Base rate cuts, directors buying their own shares and valuations at low levels are the three factors I expect to drive a sustainable recovery,” says Mr Nimmo. “UK plc's balance sheet is being repaired quite quickly as fund managers scramble to rotate their portfolios into recovery stocks. Savers want more than the paltry interest they can get in the bank. All this amounts to a virtuous circle that points to the likelihood of smaller companies having a big year in 2009."

Alan Brierley, director of investment companies at Collins Stewart, is more cautious about the outlook for the sector, saying: “UK small caps have participated in the recent ‘recession-not-depression’ relief rally. However, future progress would seem to be tied in with that of the underlying economy. For those who subscribe to Alistair Darling’s view that the UK economy will return to growth in the second half of the year, small caps could well extend their recent outperformance. However, we are less sanguine. We remain concerned about the duration and depth of the recession and the shape of the eventual recovery.”

While Mr Brierley remains guarded on the prospects for UK small caps, for those investors wishing to up their exposure, he favours the Standard Life Smaller Companies Trust, saying that Mr Nimmo has constructed the most consistent performance record in the sector.

Mr Nimmo has managed the Trust since Standard Life Investments was appointed as its manager in September 2003. Since then it has been one of the top ranking UK smaller company investment trusts - significantly outperforming its smaller company benchmark, the Extended Hoare Govett Smaller Companies Index.

The trust invests in an actively managed portfolio of smaller and mid-sized companies in the UK equity market with the aim of achieving long-term capital growth. In February this year, shareholders approved the merger of the trust with the Gartmore Smaller Companies Trust. "Both trusts where suboptimal in size terms - the merger has doubled the assets under management and created a single class of shares for the merged Standard Life vehicle. This has given way to greater liquidity in the underlying shares," says Mr Nimmo.

The trust's investment process seeks to identify tomorrow's big earners today, explains Mr Nimmo. "We prefer quality and resilience in company business models, with low levels of risk. Ultimately, we run our winners and cut our losers.” That said, the fund has a very low turnover - tending to hold shares for around four years on average.

Recent additions to the fund following the Gartmore merger include the Management Consulting Group, a company which drives efficiencies in business, JD Sports and Evolution Securities, an investment bank geared towards small and medium-sized business.

Mr Nimmo says that the investment process of the trust tend to work well four years out of five, with the fund tending to underperform the early stages of a recovery market. "I am expecting very strong markets in 2009 - as much as 50 per cent up - so even if we underperform a recovery, you are still going to get very attractive returns from the trust. If I am wrong, and this is a false dawn, our investment process which centres around resilience and quality will tend to be more robust in terms of prices holding up on the underlying holdings."

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Source: Standard Life Investments, Datastream, *Morningstar

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