Small-cap struggles mask potential

But the bare facts - that the FTSE Small Cap index returned just 0.8 per cent by the beginning of December and that the junior Aim market has once again belied its 'fast growth' status by giving up 13 per cent over the year - fail to tell the whole story. In what has been a difficult year for investors across the board - the blue-chip FTSE 100 has risen just 2 per cent and the UK-centric FTSE 350 2.3 per cent - small-cap investors have had to battle at least three strong factors. Firstly, the small-cap indices outperformed their larger peers in 2013 and also returned a solid performance in 2012, picking up as the very early green shoots of economic recovery began to show through. Couple this with the theory that smaller companies tend to flourish in the earlier stages of a bull market before larger companies play catch-up and smaller companies were left looking rather fully valued by the turn of this year, a situation that history tells us rarely lasts too long. So a correction was always a possibility.

Secondly, heightened risk aversion and volatility hit UK equities at various times during 2014, most notably during October; this is never good for smaller companies as investors inevitably seek safety in larger companies with defensive characteristics.

Thirdly, and probably more important where Aim is concerned, has been the continued rout among smaller resources stocks.

Aim has been the favoured home for early-stage resources stocks for many years, and is now packed with oil and gas explorers and producers, from the more established North Sea players to the early-stage and highly speculative explorers seeking pay dirt from the Falklands to Vietnam, as well as miners from all corners of the globe. With more than 300 companies, or over a quarter of the Aim index, in the oil and gas or natural resources sectors, a poor year for resources stocks, exacerbated by the recent slump in the oil price and the continued depression in commodity prices, has weighed heavily on the index.

Indeed, six of the 10 worst performing Aim stocks over the past year are resources plays and six of the top 10 worst performers in the Aim 100 were also resources stocks. We also saw significant share price collapses from other major Aim stocks which are widely held by private investors, including Asos (ASC) and Quindell (QPP).

Rather surprisingly, Aim's worst performing sector wasn't the oil and gas sector, but retail, although it is a much smaller sector and has suffered particularly due to the poor performance from online retailer Asos, whose shares have more than halved in value since their early-year peak. As one of the three biggest stocks on Aim, this has also dragged down the index. Overall, the wider oil and gas sector had shed 43 per cent by the beginning of December, with the basic resources sector down 35 per cent.

The strength of the property market was reflected in the fact that the real estate sector hugely outperformed all others, with an average return of 42 per cent - more than double the next best performing sector, healthcare.

Sector performance

But Aim has by no means been a wasteland for investors. In fact, it has proved to be more popular this year than it has for several years. Buoyed by the fact that Aim stocks can now be held in Isas, interest in the junior market has risen this year, with trading turnover in Aim shares by the end of November surpassing the total recorded in each of the previous five years and the number of bargains and total shares traded on the exchange both setting new records. The new issues market has also proved healthy, with 101 new companies having come to Aim by the end of November - the highest number since 2008, and raising £5.1bn between new issues and secondary fundraisings in the opening 11 months of the year. Although this remains a shadow of the £16.1bn raised at the peak in 2007, notably, the mining and oil and gas sectors between them have managed to raise close to £900m despite their travails.

And a glance at the best performing companies on Aim during the year suggests that stockpickers who avoided the resources rout could have enjoyed very decent returns indeed. Companies such as GW Pharmaceuticals (GWP), Hutchison China Meditech (HCM), Plus500 (PLUS) and CVS Group (CVSG) returned between 75 per cent and 150 per cent during the past year.

Among the new issues on Aim during the year are a number focused on the consumer or housebuilding sectors, including building products companies Epwin (EPWN) and Entu (ENTU), cafés business Patisserie Holdings (CAKE), retailer Shoe Zone (SHOE) and local telecoms business Manx Telecom (MANX). Another notable new entrant was property company Secure Income Reit (SIR), whose management team is headed by renowned property investor Nick Leslau. Anecdotal evidence suggests that the new issues market could remain buoyant through the early months of 2015, especially as a number of companies were put off coming to market in the pre-Christmas period by the equity market wobble of October and may be tempted to poke their head above the parapet in the early months of the year if conditions remain relatively benign.

Small-caps fare better

For the FTSE Small Cap index, the resources effect is less dramatic. But a glance at the worst performers among the FTSE Small Cap universe shows resources companies such as Petropavlovsk (POG), JKX Oil & Gas (JKX) and Kenmare Resources (KMR) again leading the way, along with other companies that have suffered particular individual issues, such as Partnership Assurance (PA.), whose annuity business was blown apart by the chancellor's surprise decision to scrap the compulsory purchase of annuities, ITE (ITE), whose exhibitions business has been hammered by Russian exposure and Xaar (XAR), a specialist printer hit hard by the slowdown in Chinese property and construction.

The FTSE Small Cap’s top performing companies prove the theory that consumer-related small-caps will outperform when the UK economy is recovering, with the likes of food retailer Greggs (GRG), storage specialist Safestore (SAFE), Spirit Pub Company (SPRT) and paving specialist Marshalls (MSLH) among the top performers. The strong performance of property is also borne out by the presence of the likes of Mountview Estates (MTVW), medical property group Assura (AGR) and Town Centre Securities (TCSC) - among the best performers of 2014.

FTSE Small Cap - the best and worst

What is clear from the disappointing returns during 2014 for the small-cap universe as a whole is that stockpicking is now clearly the order of the day. Sectors such as oil & gas and natural resources are likely to remain under considerable pressure during the early months of the year as the twin challenges of the low oil price and slowing growth in powerhouses such as China will continue to weigh on shares. Other sectors that could remain under pressure include food producers, which are being squeezed by the weak showing among the UK's major supermarkets, compounded by food prices slipping into deflationary territory. Also, some companies are likely to find the continued poor economic conditions in the eurozone an ongoing drag, with little sign of light at the end of the tunnel in terms of an economic recovery there.

But companies focused on the more buoyant areas of the UK economy - housebuilders, building products companies and other wider consumer-exposed sectors - are likely to fare better. But there are potential hurdles to overcome here, too, not least the general election now less than six months away. This could throw unexpected political hurdles in the way of investors, with the property market the latest to be used as a political football.

What is certain is that small-caps will remain a potentially rewarding hunting ground and, with wider market valuations having been reined back in during the year, small-caps are beginning to look like decent value again. If the UK economy continues on its recovery trajectory and we finally see a prolonged period of wage growth to accompany it, consumers could begin to loosen the purse strings once more. This should allow discerning investors to pick up decent consumer-facing stocks at a favourable point in the cycle.

Smaller companies from afar

The small-cap investor need not confine their selection to these shores any more. There have long been actively managed funds that invest in smaller companies overseas, although these attract the usual management fees for investors relying on the expertise of others.

But the advent of low-cost ETFs and tracker funds means UK investors can now access overseas smaller companies indices more easily than ever before. And one market that looks particularly interesting is the US smaller companies sector. With the US economy beginning to fire on all cylinders, domestically focused smaller companies could be well placed to take advantage and, looking at the longer-term record of outperformance of US smaller companies, their potential is clear.

Leave it to the professionals

Investors who prefer to commit their funds to the hands of professionals might want to consider closed-end funds such as Gervais Williams' CF Miton UK Smaller Companies Fund, which has returned 14 per cent in the past year despite the difficult market conditions, but it does not have a long track record. Funds such as Giles Hargreave's Marlborough UK Special Situations Fund have longer track records. It has returned 8 per cent over the past year and 134 per cent over five years. Other top-performing small-cap funds include Liontrust UK Smaller Companies Fund and Axa Framlington UK Smaller Companies Fund, which have grown by 133 per cent and 127 per cent over the past five years respectively. Investment trusts with similarly solid five-year records include Chelverton Growth Trust (CGW), Athelney Trust (ATY), Invesco Perpetual Smaller Companies (IPU) and Aberforth Smaller Companies (ASL).

Small-cap wins

Although small-caps can produce impressive short-term returns, it is their long-term record that is the most compelling reason to invest in them. Money committed to smaller companies over the long term tends to outperform that invested in larger companies significantly. Indeed, the Numis Smaller Companies Index, which is compiled by London Business School academics Elroy Dimson and Paul Marsh, has data going back to 1955 that suggests that small-caps outperform significantly and consistently on a long-term basis. Over the past 60 years the Numis Smaller Companies Index, which takes the bottom 1,000 companies each year by market value, has returned an average 15.6 per cent per year. Data from MSCI also suggests a similar effect in 30 overseas markets where small-caps have outperformed larger companies by 6.7 per cent a year on average in data going back to 2000.

In 2014 US small-caps have underperformed the S&P 500. This is hardly surprising given that the blue-chip index has been setting new record highs on pretty much a monthly basis. The S&P 500 has risen by around 12 per cent so far in 2014, while the S&P Small Cap 600, an index of smaller companies, has risen by less than 3 per cent and the Russell 2000 index of smaller companies has risen by 2.6 per cent. But this has had the effect of closing a valuation anomaly that had opened up after the S&P Small cap 600 and Russell 2000 had outperformed their larger peer last year, when both rose by more than 30 per cent. Looking at the longer-term record, the S&P Small Cap 600 has risen by almost 150 per cent since 2009, beating the 120 per cent advance of the S&P 500 and in that period the smaller companies index outperformed its bigger cousin in four out of six years. With analysts expecting small-cap earnings growth to pick up in the US next year, boosted by the weakening oil price effect on the economy, getting some smaller companies exposure here could be rewarding.

This is echoed by US investing expert Kully Samra of Charles Schwab who told us: "The prospects for small-caps in the US are very good. The consumer has gone through deleveraging, the fiscal drag from the government is gone and higher capital expenditure is expected. Mid and small-caps will benefit the most. True, dollar strength hurts exports but only 13 per cent of the US economy is dependent on exports, consumer spending is 68 per cent of the US economy and we're finally looking at wage growth in the US."

ETFs that track US small-cap indices include the ETF Securities Russell 2000 ETF and the iShares S&P 600 ETF. Actively managed funds worth watching for US smaller companies include Vanguard US Discoveries Fund, which has grown more than 210 per cent over five years and JPMorgan US Smaller Companies Fund, which has returned 116 per cent.

Elsewhere, Asian smaller companies have a good track record, too, with actively managed Asian small and medium companies funds averaging an 87 per cent return over five years, the best performing sector among Asian equities. The universe here is small, though, with only a handful of funds. Notable performers include HSBC's Asia ex-Japan smaller companies Fund, which has returned 103 per cent in five years and Aberdeen Asian Smaller Companies (AAS), which has returned 99 per cent. In the ETF sphere, iShares has an ETF that tracks the MSCI Far East ex-Japan index.

For those investors with an eye on a potential recovery in European equities in the future, a number of actively managed funds and ETFs also invest in European smaller companies, with JPM Europe Small Cap Fund and JPM Europe Smaller Companies Trust (JESC) and Schroder European Smaller Companies Fund among the top performing actively managed funds over five years.