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Three reasons to go small

FUNDS: Small-cap fund managers are far from despairing about the outlook for small companies
July 5, 2010

On the face of it, the outlook doesn't look promising for small-cap shares. Investor risk aversion is rising, credit is still hard to come by even for large companies, let alone small ones, and the UK looks set for a period of unprecedented public-sector austerity - and a possible return to recession. However, many smaller companies are now better run, better financed and more international than ever before - so there are still plenty of opportunities there for small-cap fund managers.

There are several key reasons to be optimistic about the future for small-cap shares, according to fund managers active in the small-cap space.

Internationalisation

Historically, UK smaller companies funds have had a rotten time in economic downturns partly because the firms they were investing in were heavily exposed to the UK economy. of the very nature of the companies they are investing in. "In the early 1990s, smaller caps were very much more UK-oriented and heavily concentrated in the manufacturing sector - engineering, textiles, paper and packaging, specialist chemicals - as well as building and retailing. Many of those industries have more or less disappeared from the UK," says Harry Nimmo, manager of Standard Life's UK Smaller Companies fund

That's no longer the case. Tom Tuite Dalton, of broker Oriel Securities, notes that in many smaller company trusts and funds, upwards of 50 per cent of portfolio earnings are generated overseas: he highlights Aberforth Smaller Companies Trust as a prime example.

Mick Gilligan, head of research at stockbroker Killik & Co, agrees. He notes that Legal & General UK Alpha, a multi-cap fund that currently holds about 75 per cent smaller companies, owns shares in China Meditech, an Alternative Investment Market (Aim)-listed Chinese healthcare play, Xaar, an inkjet printing business focused on Asia, and Aim-listed Malaysian data centre CSF Group.

There's also much more sectoral diversification, with IT and software, healthcare and oil and gas. companies joining old stalwarts like retail and property. That change of emphasis makes not only for a broader based universe of small companies, but also for a less UK-focused one.

Valuations

By most measures, small-caps are cheap. At Aberforth Smaller Companies, Alastair Whyte points out that at the end of April, the FTSE Small Cap index was trading on a trailing price/earnings ratio of 10.9, compared with the FTSE 250 on 13.6 - a 20 per cent differential. "Such a significant differential is rare and reflects the premium awarded to liquidity and to perceived overseas earnings, given an almost universal negative view on the UK economy," he explains.

Such lowly valuations, combined with the weakness of sterling, have prompted overseas interest. Mr Whyte reports 12 deals or discussions in the first half of this year among Hoare Govett Smaller Companies index members. Recent scraps over Scott Wilson and Chloride are cases in point.

Dividends

Last week, we highlighted how more and more investors are turning to the mid- and small-cap arena for income, as the blue-chip companies upon which they have traditionally depended for income fall upon hard times (see ).

"Some small cap funds are now offering similar yields to funds in the income growth sector, with, in our view, equal if not superior scope to grow underlying earnings," says Tom Tuite Dalton.

Mr Whyte concurs, pointing out that "dividends have surprised on the upside," with the majority – around 80 per cent – of Aberforth's holdings actually increasing their payouts this year. As a consequence, he expects the trust will increase its own dividend this year and next.

Gervais Williams, who heads Gartmore's smaller companies team, goes further still, arguing that the latent dividend potential of small-caps is huge. "At the moment, 80 per cent of Aim stocks don't pay dividends - yet many are in a position to do so, with cash on the balance sheet, increasing profits and expectations of growth," he says.

He has actively lobbied investee companies to join the dividend list, arguing that doing so would vastly enhance their appeal to investors. "I have had a few early successes," he says, citing career transitions consultant Penna, whose shares now yield six per cent.

Risk factors

None of this is to deny that small-cap share prices can be more volatile and that the underlying companies are riskier than their larger cousins - although Mr Nimmo points out that of the top twenty companies in the UK, five have "almost gone bust in the last ten years".

Small companies are less likely to be able to secure credit in straitened times, and less likely to be able to absorb sudden financial shocks. That's one reason why the recent Budget was closely scrutinised by small-cap fund managers.

There are fears that the VAT hike to 20 per cent will impact on consumer demand; the Federation of Small Businesses points out that it will hit small enterprises particularly hard as they don't have the resources to absorb the costs and so will have to pass them on to customers.

The general brutality of the cuts may also create an environment of retrenchment and risk-aversion that's detrimental to small-caps. Mr Gilligan warns that in the event of a slide back in to recession, "we'd expect to see a flight to liquidity with small caps dumped in favour of large ones."

On the plus side, though, reductions in corporation tax next April (from 21 to 20 per cent for companies with less than £300,000 of profits; and from 28 to 24 per cent over the next four years for larger firms), increases in entrepreneurs' relief on capital gains from £2m to £5m and higher employer national insurance thresholds are all welcome.

Mr Williams is even more upbeat. "Given the slashes to the public sector announced in the Budget, there's a clear need to create private sector employment, and small businesses will be highly instrumental in that," he comments. "The government is putting together a policy paper over the next few weeks on how to encourage small caps going forward, and I see that as really positive."

Mr Nimmo says the Budget was "pretty much as we expected it to be." He expects companies heavily dependent on government spending to struggle, with Connaught a case in point. It provides property services for the public and social housing sectors, and after the Budget. A wide range of construction and built environment firms - typical smaller company fund staples - are up against similar problems.