As valuations skyrocket and yields plunge, Rebecca Jones asks three managers whether the five year bull run in smaller companies may be coming to an end...
David Hambidge, head of multi-asset, Premier Asset Management
We are at the five-year anniversary of the start of the equity bull market. Over that time, the FTSE Small Cap index is up nearly 250%, while the FTSE 100 is up 110%. Neither return is to be sniffed at but one is obviously much higher.
Of course, small-caps got a complete pasting in the credit crunch, so part of this recovery has come because they were rising from a very low base. However, from a valuations perspective, we think they have gone beyond fair value.
While recent data from the IMA shows inflows into smaller companies have never been stronger, we would question the wisdom of that at this point of the cycle. We were very happy to take profits from our small-cap holdings recently.
Since the Numis Smaller Companies index was launched in 1955, it has returned about 3.5% more than larger UK companies.
However, last year it returned 16% more. While that is not a reason on its own to sell, I would suggest it is a reason to be cautious. Over the last five years, we have seen what are termed ‘super-normal returns' from UK smaller companies.
You are also not getting nearly as much dividend yield from the smaller companies index as you are from larger companies.
We do like smaller companies and have always invested in them. They tend to have faster growth and, therefore, yield a higher return on capital and that has been the case historically. However, really, I would suggest the safer way of playing the stock market it at this point in the cycle would be in large cap, not small cap.
Darius McDermott, managing director, Chelsea Financial Services
There is no doubt smaller companies have had a fantastic run, so I can see the viewpoint of those managers expressing caution on the sector.
The usual argument that smaller companies should do well in domestic recoveries, because they tend to be more domestically-focused, still holds out; however, right now, it is the job of managers to find the value.
Finding good, decently priced smaller companies is evidently more difficult, perhaps proved by the fact our preferred small-cap manager, Giles Hargreaves, has moved to 10% cash in his Marlborough UK Micro Cap fund.
Hargreaves always holds a lot of stocks and is very well diversified, so it is a comment on the asset class for him to be holding that many stocks and to say he does not want to add to any.
The market, realistically, breaks down into three sectors now: there is the FTSE mega-cap (the top 20 to 25 stocks on the FTSE 100), the rest of the FTSE 100 and the top half of the FTSE 250, then the bottom half of the 250 and the FTSE Small Cap index.
Looking purely at valuations, currently, it is the mega-caps that are cheap. However, if you asked me what you should buy over ten years, I would say small-caps, all day long. A bit of caution after a bull run is sensible but we still think, over time, smaller companies will perform.
I wouldn't say small-caps are in for an imminent pullback but I would say that, if there is a general market sell-off, least liquid and higher rated parts of the market - small-caps - are going to suffer the most.
Ian Aylward, head of multi-manager, Aviva Investors
The P/E ratio of the FTSE 100 is 17x and the dividend yield is just over 4%, whereas, for the FTSE 250, the P/E is up over 20x and the dividend yield is barely 3.5%. For the Small-Cap index, the yield is right down at barely 2%.
So, relative valuations are quite stretched and, of course, the returns from small-caps have been tremendous over the past five years, returning almost double that of large-caps. We are very cognisant of that performance discrepancy.
Until about six months ago, we held the Fidelity UK Smaller Companies fund. We also came out of the Hermes US Mid-Cap and Findlay Park American funds at about the same time, as we would argue valuations in the US are even more stretched than in the UK.
The only fund we have left with a very overt mid-cap bias is in Europe, in the Barings European Equity fund, which definitely has a mid-cap focus. We think there is further scope for European mid-caps to close the gap relative to the US and UK.
Of course, in this industry, it is difficult to call an exact point and to see a catalyst coming, which is why we take steady views and make steady trades in and out of funds. The return to mid- and small-caps continues to be strong, so perhaps by exiting in the last quarter of last year we were a little early - but we can live with that.
Having come out of the space when we did, however, we would hope to see some degree of correction within the next six months. What the catalyst will be and when it will happen, however, I do not know.
Tony Lanning, portfolio manager, J.P. Morgan Fusion funds
J.P. Morgan Fusion funds have a well-diversified portfolio of UK managers including a specialist UK smaller companies manager, Aberforth. It represents up to 4% of each of the five risk-rated Fusion funds
Aberforth has a disciplined value bias and after a period of understandable and explainable underperformance (when growth was outperforming value) we took the opportunity to gain exposure to what we considered to be a cheap area of the small-cap market.
Despite strong returns since we purchased the fund, it remains high conviction. The portfolio remains cheap relative to the FTSE Small Cap index (which is trading just at over 8x EV/EBITDA)
Attractively valued companies should be beneficiaries of an increasing amount of merger and acquisition (M&A) activity. Many of the ingredients for this were in place last year, companies have record levels of cash on their balance sheet and the lure of growth through industry consolidation remains compelling.
However, activity remained low, which can only be explained by continued low levels of confidence. We are more optimistic and feel confident that the UK domestic economy remains strong while we expect global growth to remain subdued, but - importantly - improving. We would expect this environment to lead in time to increased M&A activity that should benefit smaller companies.
Most importantly, we believe that after a period of strong performance from risk assets as a result of margin expansion, earnings growth will become the key driver of returns in 2014. As a result high conviction stock pickers like Aberforth should continue to outperform.
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