A lucky year for small caps

The FTSE Small Cap performance has been particularly impressive given the anaemic performance of the UK economy, when one might expect small caps to have underperformed. But a large number of constituents of the FTSE Small Cap index are actually in pretty good shape despite the state of the domestic economy, the mess our near European neighbours are in, the slowing growth in emerging markets and virtually non-existent bank credit in the UK.

The situation has not been quite so rosy on the Aim index, where the significant weighting towards the resources sector has hurt overall performance, as the wheels have come off the commodity supercycle. A peek at the performance of the different sectors on Aim over the opening 11 months of the year tells its own story with basic resources by far and away the worst performing sector with a 28.6 per cent reversal in value and oil struggling to keep its head above water with a gain of just 2.7 per cent. Contrast this with a stunning 77 per cent gain in the retail sector and a 76.6 per cent gain in the banking sector - although these two are helped by being home to a mere handful of stocks.

During the year, Aim has continued to shrink, with a trickle of admissions being outweighed by a steady stream of companies departing the index. By the end of October, the index was home to 1,102 companies, down from 1,143 at the end of 2011. New money raised for admissions remained modest this year, totalling £447.9m in the first 10 months against £608.8m in the whole of 2011, and even secondary raisings are down on the previous year at £2bn. In its heyday, in 2007, Aim companies raised a cumulative £16.2bn. But, encouragingly, investor activity on Aim has picked up this year, with the average daily value of shares traded and the number of bargains transacted both running at their highest levels since the financial crisis.

And some investors believe that conditions are ripe for investing in smaller companies and returns are likely to be strong in 2013. Smaller companies fund management veteran Gervais Williams, who ran Gartmore's smaller companies team for many years before joining MAM Funds in 2011 thinks so. He is in the process of setting up a small-cap fund to complement the Diverse Income fund, which he has grown successfully since launch in April 2011. The Diverse Income fund invests primarily in smaller companies and seeks to pay a 4 per cent dividend yield. Mr Williams aims to use some of the ideas that do not qualify for his income fund to populate his new small-cap fund.

A structural shift to small caps

Mr Williams is a long-term bull of the smaller companies sector, believing us to be in the early stages of a cyclical adjustment in asset allocation down the value chain. He said: "There is still a huge one-off benefit to come. We are seeing allocations of long-term capital into the small-cap sector for the first time in 25 years. People are accepting that as the world goes to a slow-growth environment, and with QE unwinding at some stage, there is a greater willingness to start pursuing individual stocks. As this happens, funds reallocate down to the small-cap sector, which means we will see the sector regularly outperforming, which gets the bandwagon going again."

He believes that, over the next five to 10 years, institutions will shift up to 10 per cent of their capital into small-cap shares and, coupled with the relatively illiquid state of small-cap markets, this will produce "stunning value".

But, as with the Aim market this year, the growth will not be indiscriminate. Investors will still need to pick companies with strong balance sheets, decent growth prospects, cash generation and, in most cases, some element of dividend yield. Pick the right stocks and they could double in size in relatively short order. Mr Williams identifies sectors where companies have pricing power and the ability to innovate and introduce new products such as food producers or services companies, like insurance services.

Of course, such confidence could easily be knocked off course by the failure to resolve the fiscal cliff in the US or another blow-up in Europe. If this happens, smaller companies are likely to be hit harder than most as investors will once again withdraw from riskier assets.

But optimists point to progress being slowly and painfully made in Europe, and in the US there is hope that a last-minute deal will be struck. Following on from a strong end to the year for equities, this could provide a recipe for equity market strength and, if so, small caps are likely to be at the forefront of that outperformance.

FTSE performance 1 Jan-30 Nov 2012

Picking small-cap winners

The small-cap arena will remain one for stock-pickers, though, and if global economic growth is in for a subdued period then resources stocks could once again underwhelm. But there are plenty of companies on both the small-cap and Aim indices that offer significant value. There remain many long-term growth stories such as Asos (ASC), Carr's Milling Industries (CRM), Cineworld (CINE), Tribal Group (TRB), Dart Group (DTG) or Sanderson (SND). Numerous value situations also exist, including the break-up plays LMS Capital (LMS) and Trading Emissions (TRE) or API Group (API), which is up for sale.

Resources stocks cannot be completely ruled out either, with Aim stocks such as Columbian oil explorer Amerisur Resources (AMER) still likely to flourish due to its active drilling programme and Plexus Holdings (POS) beginning to gain traction in its end markets. But there is a sense that a number of resources companies on Aim are beginning to run out of time to prove their prospects out before they run out of cash with investors in many cases unlikely to stump up to fund speculative exploration.

It appears that investors are more comfortable with the more established companies of the FTSE Small Cap index than the often earlier-stage companies of Aim and this may remain the case while the economic situation is still fragile. What is certain is that there are a large number of prospects on both the Small Cap and Aim indices that still offer investors solid growth prospects - and even decent dividend yields.

FTSE Small Cap winners/losers