Small-cap stars

The Alternative Investment Market (Aim) decided to belatedly join the party, gaining 15 per cent up to the beginning of December after a flat performance in 2012. Compared with the blue-chip FTSE 100’s return of 8 per cent, this represents a significant outperformance, although the mid-cap FTSE 250 ran the Small Cap index a little closer with a 20 per cent gain. Notably, the stand-out performance was delivered by the FTSE Fledgling index, which gained 34 per cent in the period to the first week of December.

For Aim, in particular, this overall performance is impressive given that around one-quarter of the index is still made up of oil and gas and mining shares, which have struggled during a subdued time for resources equities. In fact, for the second consecutive year the Basic Resources sector was the worst-performing sector on Aim, shedding 32 per cent of its value while the Oil and Gas sector was a little more resilient, falling only 10 per cent.

The strong performance of smaller companies during 2013 is partly explained by the slowly emerging recovery in the UK economy, given that small caps tend to be more tuned into the domestic economy and often outperform during periods of economic recovery and sustained strength, especially when this is accompanied by a rise in risk appetite among investors, such as that witnessed in 2013.

Aim sector performance

Isa boost

A glance at the top 10 performers in the FTSE Small Cap index up to the end of November illustrates this point perfectly with the likes of retailer Topps Tiles (TPT), parcels business UK Mail (UKM), posh cookers manufacturer AGA Rangemaster (AGA), builder MJ Gleeson (GLE) and building products specialist Marshalls (MSLH) all having risen by 80 per cent or more during the period. Aim is more diverse - it is home to more than 1,000 companies, and features outliers such as oil and has seismic services specialist Thalassa (THAL) and Hayward Tyler (HYT), a manufacturer of specialist pumps and equipment to the global energy industry, among its top performers.

One of the most notable events for Aim during 2013 was the qualification of Aim stocks for inclusion in independent savings accounts (Isas) wrappers, which was approved in early August. This prompted a significant uplift in the volume of shares traded on the market and also coincided with an uplift in the overall performance of the market as investors scrambled to put the best Aim stocks in their Isas.

The volume of Aim-traded shares leapt from 15.8m shares traded in July to 31.7m in August, a level that has been sustained in the months since.

Some Aim stocks also qualify for inheritance tax (IHT) relief, dependent on whether they qualify for business property relief as a business and if the shares have been held for two years or more, which also increases their attraction for retail investors.

FTSE Small Cap Top 10

New entrants

The sustained strong performance from the FTSE Small Cap index coupled with the long-awaited recovery in confidence in Aim also led to a flurry of new issues during the second half of the year. By the end of October, Aim had welcomed 73 new issues, more than the 71 it saw in the whole of 2011 and the final reckoning will probably see in the region of 100 new issues for the first time since 2009. This still remains a long way short of the peak years of 2005 and 2006, when more than 900 new issues in aggregate joined Aim. But the junior market looks to be regaining its reputation as a promising hunting ground for companies in the early stages of growth which need capital investment from a stable source. As well as a flurry of technology companies such as Graphene Nanochem (GRPH) and Kalibrate Technologies (KLBT), Aim also welcomed companies plugged firmly into the UK economy such as Bargain Booze owner Conviviality Retail (CVR), mature ladies fashion retailer Bonmarche (BON) and lettings agent Martin & Co (MCO).

And it is not difficult to see why retailers may be looking to the equity markets for their next leg up in terms of expansion given the strong performance of the retail sector over the past two years in share price terms. In the first 11 months of the year, the retail sector was the top-performing sector on Aim, rising 99 per cent, almost double the next biggest riser, telecoms, which grew by 50.2 per cent in the same time frame.

The relative success of many of the recent new issues, helped by their release into buoyant markets, has rekindled confidence in Aim as a viable port of call for raising equity and bodes well for its continued success in attracting new issues during the early months of 2014, assuming the UK economy remains buoyant.

Aim Top 10

Small future

But can small caps maintain their outperformance for a third year in a row? History would suggest that is a tough ask, but if the UK economy continues to recover at the pace already forecast, then there is little reason to suspect that smaller companies won’t thrive again. What’s more, valuations are not yet stretched, according to small-cap fund manager Paul Mumford of Cavendish Asset Management. "Small caps ratings are still pretty good. What’s more, people looking for share price performance will move down the scale. Judging by individual shares, there is still tremendous value out there," he said.

He highlighted electrical components specialist XP Power (XPP) as an example of a "stock that has blown the lights out but is still not expensively priced". He also nominated Advanced Medical Solutions (AMS), Eckoh Technologies (ECK), Monitise (MONI) and Emis (EMIS) as solid profit-making companies at decent valuations and the electronics sector contains companies such as Zytronic (ZYT), which is valued at 14 times earnings and yields 4 per cent. Property is another area where smaller company investors can still pick up bargains and portfolios valued at compelling discounts to net assets, including Simon Thompson's recommendations such as Conygar (CIC) and Mountview Estates (MTVW).

Mr Mumford reckons that if equity markets continue to remain buoyant then "stocks that are trading at 12-15 times earnings could become growth stocks at 20-25 times earnings". He believes that the recent regulatory changes have created a "compelling reason" for buying equities and that we are currently "nowhere near the stage where you have to start worrying". He remains bullish on small caps' potential, saying: "There are potential 10-baggers all over the place". He also predicts a continued resurgence of the initial public offering (IPO) market and is also willing to go against the grain and buy in the oil and gas sector, which has underperformed for the past two years, but selectively, recommending companies such as Ithaca Energy (IAE) which is still valued at 1.5 times earnings.

What looks increasingly likely is that well directed investment in the right smaller companies can be a hugely profitable exercise. This can either be done through one of the top-performing unit trusts investing in this sector, such as IC Top 100 Funds constituents such as Standard Life UK Smaller Companies, Henderson Smaller Companies or the Marlborough Micro Cap Fund or one of a number of top-performing investment trusts including the Acorn Income Fund (AIF). Some brokers, such as Charles Stanley, also offer an inheritance tax portfolio service which is based on investments in Aim stocks; its model portfolio returned 36.5 per cent in the 12 months to the end of September.

The smaller companies markets have been a happy hunting ground over the past 12 months and look set fair for further decent performance in the early part of 2014 as long as the UK economic recovery remains on track. There are an increasingly large number of quality smaller companies on decent ratings which, having battened down the hatches during the tough post-financial crisis years, are now set to take advantage of the economic recovery which should lead to accelerating earnings and, increasingly, growing dividends, too.