Managers predict valuations will be forced lower before rebounding in the fourth quarter
Current market conditions will force small-cap valuations lower before the asset class starts to recover, according to UK smaller companies fund managers.
Liquidity problems and a lack of confidence led by accounting scandals in the US will cause further turmoil for the sector, at least through the summer. But a rebound is anticipated in the second half of the year, possibly as late as the fourth quarter.
Alex Ross, smaller companies fund manager at Aberdeen Asset Management, expects things to worsen before they improve.
He has held a defensive stance in his portfolio over the past 18 months, primarily through being underweight in media and software. He plans to maintain that stance, at least until more positive newsflow starts to emerge.
Year-to-date, smaller companies have outperformed blue chips but Ross does not expect that to continue, believing they will underperform in the third quarter.
'Investors are going to start to identify those quality companies that have solid earnings and are producing decent results,' he said.
'Toward the end of this quarter, as institutions come back and start playing the market again, we will begin to see reasonably positive fourth quarter results from UK companies and I'm expecting a reasonable return.
'Our portfolio is currently trading on 10-11 times earnings. We would say usually this is cheap and therefore a buy but we don't trust the E figure in that ratio. We are very cautious in the short term as we expect analysts might be being too optimistic.'
Alistair Currie, smaller companies fund manager at Edinburgh Fund Managers, is fully invested, with 0% in cash, a move he believes has been a mistake.
He anticipates tough times to last throughout the summer as sentiment is so poor it is difficult to see it turning swiftly. Fears of accounting scandals have centred on the US but there are also concerns here in the UK for both small and large companies.
Currie said: 'Many of the growth stocks are looking cheap. Over the past two years, since the peak of the tech boom, it has become apparent which were quality businesses and which were mere hype but everything seems to be tarred with the same brush. When the recovery comes, the potential is there for these companies to recover dramatically.'
As a growth manager, Currie is overweight in the software and media sectors.
Roger Whiteoak, UK manager at Framlington, said: 'At current valuations, and assuming some sort of recovery, however slight it emerges, the valuations in the small-cap market should go up by 30% over a two-year period. Having said that, it is likely that in the next two months the market could go down further before it begins to go up again.'
Whiteoak added that when a recovery comes, it could be rapid, with many of the 30% gains he expects coming in a short period of time.
Areas where Whiteoak is finding value include housebuilders and construction, as well as specialist financials. However, some biotechnology and technology companies offer good buying opportunities, he believes.
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