Last week the Office for National Statistics reported that the UK economy has moved into its third quarter of the double dip recession, with gross domestic product (GDP) down 0.7 per cent in the three months to June. Most economists are also predicting another negative quarter of growth. The conventional wisdom is that in such times the best option is large-cap blue-chip stocks, which are more defensive because they tend to be strong, cash rich and pay dividends so you get something, if not growth. Small-caps, meanwhile, are typically less strong and more exposed to their domestic economies.
But things are never black and white. "Not all large-caps are defensive because there are also cyclicals at this end of the market, and while you have to be careful with smaller and mid-sized companies these have a great advantage in that they are typically more focused and adaptable," says Richard Plackett, co-manager of the BlackRock UK Special Situations Fund, which has the ability to allocate to all sizes of UK shares. "Because they are smaller and growing it is easier for them to reschedule their business relative to a larger company doing business in lots of areas – it's why smallers have historically outperformed. There is a case for adding large-caps because they are cheap but the trend rate of growth falling in the developed world means it should be subdued for a long-time so you need to find high quality companies which can grow."
"The conventional view that large-caps are safer at times like this is wrong," adds Gervais Williams, manager of the MAM ACUIM UK Multi Cap Income Fund. "People feel safe because large-caps are often strong brand names which have large market shares but there are also dangers in that these are vulnerable to global economic trends which at present are cautious: China continues to slow and even the US is not growing at a strong rate."
It is important to find companies which can expand in current circumstances, such as Fairpoint which specialises in debt rescheduling and solutions for financially stressed consumers, services particularly in demand just now.
Meanwhile, you might expect UK house builders to be doing badly but some are benefiting from a supply contraction in certain areas. Mr Plackett has invested in smaller housebuilders with strong balance sheets such as Bovis which has refocused itself on the south and south east. Read more on Bovis
Read more on Housebuilders in a sweet spot
Mr Plackett admits that over the last five years large companies have outperformed because they are defensive and pay good dividends, so are popular. "But it is dangerous to buy large-caps when the world is already pessimistic, rather this is the best time to buy small-caps."
Mr Williams also emphasises the importance of low valuations, saying that smaller companies' valuations are around two thirds of those of large-caps.
Meanwhile, Mark Martin, manager of Neptune UK Mid Cap Fund says: "Opportunities are invariably thrown up in the most beaten-up areas of the market as investors crowd towards hot stocks with the strongest momentum. Provided these value stocks are not in structurally flawed markets, low valuations and negative investor sentiment actually reduce risk and diminish the potential for downside surprises. The potential for reward is very significant. It is notable that recent mergers and acquisitions (M&A) in the UK market have focused on value-type stocks such as Logica, WSP and Nautical Petroleum. Attracted by the UK's stable monetary, political and regulatory environment, suitors have approached these companies offering significant premiums."
Longer-term small and mid caps have outperformed. Over the last 55 years these have outperformed larger companies by 3.5 per cent a year, according to Mr Plackett. He says if you had invested £100 in smaller companies on 31 December 1955 at the end of June this year it would be worth £350,034, whereas in larger companies it would only be worth £53,443.
Long-term drivers of small and mid-caps include their:
■ faster organic growth;
■ higher operational leverage;
■ source of new technology and services; and
■ the subject of mergers and acquisitions.
Some smaller companies also get their revenues internationally. Despite short-term concerns the case for emerging markets growth remains intact and Mr Placket says this is why he owns companies with exposure to this area.
Advisers and analysts also acknowledge the merits of smaller companies."In general it is true that small and medium-sized companies are more reliant on the state of their home economy, but there are an increasing number which get a significant amount of their earnings from overseas and good stock-picking managers can also find domestically-focused small and mid caps which are resilient," says Juliet Schooling Latter, head of research at discount broker Chelsea Financial Services. "Since the start of the financial crisis, the average smaller company fund has significantly outperformed its larger company peers. While we have probably seen the best of the small cap rally from the market bottom in 2009, it is worth noting that small-cap equity markets remain below their pre-financial crisis peak."
Picking the winners in a risky sector
As only 10 to 20 per cent of smaller companies are likely to grow, according to Mr Plackett, if you or the fund you invest in do not pick the right ones then you won’t get any growth. He tries to find ones in sectors such as industrial and technology that make things which people want, for example, Senior, and ones with strong balance sheets "because if you are well financed you will survive." He also likes ones which have already shown the ability to grow such as Domino Printing Sciences and Spirax Sarco.
"Companies able to survive in a downturn, and grow significantly and sustainably over the medium-term are the types of shares which will make people money in the next five years at a time when only around 10 to 20 per cent of companies are growing," he adds.
Smaller companies may have potential for strong returns but they are higher risk as they are typically less strong than larger companies and many are still reliant on the UK. Lack of access to bank lending is a restriction as small and mid sized companies need capital to run and grow their businesses. Bad debtors are a risk because it is essential that small businesses are paid money owed on time.
Smaller company shares are less easy to buy and sell which means their share prices are typically much more volatile than those of larger companies. Even when smaller companies are trading well, sometimes this is not reflected in their share price.
Mid-caps are less volatile but do not grow as fast as some small-caps.
UK focused companies won't necessarily get a significant Olympic boost. "This is a one off so we shouldn't get excited," says Mr Williams. "But there are certain special areas which should benefit, for example marketing services and print group St Ives."
St Ives' exhibition and events business enjoyed increased activity before the Olympics started.
Housebuilders are the construction companies poised to benefit most from the upgrade in facilities and infrastructure at the Queen Elizabeth Olympic Park according to Mr Martin, because as many as 5,000 new homes could be built in the area after the Olympics.
But read more on why Olympics won't stimulate
And others maintain the case for larger companies. "We think the risk-reward profile of defensive, high-yielding blue-chip stocks is outstanding," says Bill Mott, manager of PSigma Income Fund. "In a low growth world, dividends are an increasingly important part of total return. It is hard to see how equity markets could really pick up their skirts and run. In this environment, companies that can deliver consistent growth and show good dividend progression for shareholders should be positively re-rated."
