James Faulkner on Where Next for Small Caps?

As investor sentiment has recovered in the UK, small caps have been among the chief beneficiaries of that improvement. However, in a recent interview with FE Trustnet, Standard Life UK Smaller Companies manager Harry Nimmo said investors in his fund should expect to make half as much money in the next five years as they have over the previous five.

“We are seeing volatility in both directions off the back of a smaller companies market that has been in a bull market for the past five years and an economy that has been recovering very sharply for several years too,” said Nimmo, whose excellent track record has made him something of an authority on the UK small-cap market.

“Our returns over the past five years have averaged 22 per cent a year and the index has averaged 20.5 per cent a year. That level of return is not warranted in a normal market. Things may have been overcooked in the downside of 2009 but that is a pretty spectacular five year run.”

Nimmo is not the only small-cap fund manager to strike a more cautious tone of late. As early as December 2013 Fidelity UK Smaller Companies manager Alex Wright was warning that UK smaller company valuations were beginning to look a little frothy: “As a contrarian, I have become a little more cautious following the strong market rally. The FTSE 250 and FTSE Small Cap indices are now trading at premiums to their 15-year price/earnings multiple averages.”

By contrast, Wright noted that “The FTSE 100 still looks cheap compared with its historical average and this has proved to be a fertile space for idea-generation recently.” However, with well over 1,000 companies in the mid and small cap investment universe, Wright conceded that “there are still disliked companies out there which fulfil my investment criteria of having limited downside and unrecognised growth options.”

Indeed, the sheer size of the quoted small cap market means that there will always be opportunities to be exploited in any market, but not all smaller company fund managers are as wary of the market in general. Giles Hargreave of the top-performing Marlborough Special Situations Fund said at the end of 2013 that “valuations and macroeconomics are extremely supportive of UK smaller companies, and investors should continue to buy into the asset class despite the strong run.”

Aside from the point that small caps tend to outperform during a recovery period, Hargreave said he also expected them to benefit from a continuation of the switch from bonds into equities in a development labelled “the great rotation”. However, his reasoning behind this assumption raises some questions, as it involves higher interest rates.

“I think that switch [from bonds into equities] will continue,” argued Hargreave back in 2013. “Interest rates will have to go up soon, especially when you look at recent house prices. So really, I think now is actually a very good time to be buying smaller companies.”

While there is an argument for higher interest rates feeding through into higher stock prices, as funds flow out of bonds, higher interest rates could also have a negative affect on some smaller companies. Higher rates are obviously bad news for companies with large debts, but they also pose questions in terms of valuation.

Higher interest rates imply a higher ‘risk-free’ rate which feeds through to higher required rates of return for investments. These factors are therefore potentially damaging to small caps, but as Hargreave rightly points out, “It all depends on how much they go up by. If they were to rise by 2 or 3 per cent, I don’t think it would have much of an impact.” However, if rates were to spike – perhaps in response to spiralling inflation – this would be damaging to all equities, including small caps. While the latter scenario is unlikely in the context of Bank of England Governor Mark Carney’s “forward guidance” on interest rates, it is nevertheless worth bearing in mind.

That said, moderately higher interest rates probably wouldn’t derail the current bull market, so long as they signal a shift to a more “normal” economic situation rather than a knee-jerk reaction to higher inflation. It is interesting to note that Hargreave and Marlborough recently launched a “Nano-Cap” fund in order to capitalise on the trends discussed above via investing primarily in companies worth less than £100 million.

Of course, by describing a £100 million company as “nano-cap” Marlborough is simply abiding by the rather quirky outlook of the fund management industry, where anything smaller than, say, £500 million is considered to be “small cap”. Most fund managers will not touch anything with a market cap below the £100 million mark, so Marlborough’s use of language is obviously an attempt to convey the novelty here.

While fund managers like Nimmo have seen the toppy valuations of some of their “small-caps” such as ASOS (ASC) come plummeting back down to earth, here at t1ps.com we still believe that there is still value to be found among the real small caps of AIM. Brokers anticipate a pick up both in AIM’s fundraising capabilities and in trading volumes going forward, as macro economic conditions continue to improve and the ‘ISA-ability’ of AIM stocks increases investor appetite for the market’s constituents. Moreover, as the recovery becomes entrenched, small caps, as the key drivers of growth, stand to continue to gain.