Despite a testing 12 months in the small-caps sector, the long-term prospects for cash generative, well-managed companies remain excellent and investors should keep the faith
It is something of an understatement to say that it's been a challenging few years for investors in the UK smaller companies market. From riding high at the peak of the technology boom three years ago, this asset class is in danger of becoming the underdog of the investment world, steadily underperforming larger companies and starting to test the patience of even the most experienced long term investors.
Over the past 12 months, the FTSE Smaller Companies ex Investment Trusts Index has declined by more than 30%, a significantly worse performance than the FTSE All-Share Index. This pattern is repeated over the course of the year to date and over the longer horizon on a three-year view. The direction is broadly the same as the larger market in the UK, but the magnitude of the changes and the level of volatility has been greater.
Yet, even as returns disappoint, there are reasons for starting to feel more optimistic towards this challenging asset class. It is likely to take a pick-up in the pace of economic growth and a return in investor confidence across the market before UK smaller companies show renewed liquidity and strength. Yet, share price valuations in the UK smaller companies market are compelling, and this can be see from the recent increase in the number of management buy-outs and purchases by trade buyers. We believe the long-term prospects for fundamentally sound, cash generative well managed smaller companies look excellent at these levels. This is not the time to lose faith in smaller companies.
A defining feature of the market in recent months has been the lack of investor confidence in UK smaller companies, manifested in continued stock declines and the marked lack of liquidity in this market. The continued attractive valuation levels, shown in the elevated level of management buy-outs and trade purchases have also been key. Investor confidence is, of course, a reflection of the state of the UK economy, the broader global economy, and the recent events in the Middle East.
An important consideration will be the extent to which the conflict impacts business and consumer confidence. In the first three months of the year the prospect of a war inhibited company spending plans. It is probably too early to say whether spending patterns will revive now that the conflict appears to be over.
The messages we have been getting from company management have been mixed. Some companies have been telling us that once the war is over they are expecting a pick-up in orders, others that grim reality will set in and that economic conditions will continue to be difficult. On balance, we believe that manufacturers are likely to see something of an improvement although it may take longer for this to come through to the service sectors.
A critical influence in the outlook for the UK economy will also be the oil price. If the price stays down in the mid-$20s per barrel, then there is the possibility that growth forecasts will start to be raised. If, on the other hand, it reverts to higher levels there may be further downgrades to come. At the moment, much depends on the situation in the Middle East, although again, we would expect to see a lower rather than a higher oil price as a peace dividend.
The imbalance in the UK economy between consumer and housing market strength and weakness elsewhere has continued to be a point of concern for the Bank of England's Monetary Policy Committee and investors alike. As these imbalances are resolved, the prospects for interest rates and sectoral performance will start to improve. The UK government sector is perhaps the area of the economy which has seen strongest growth lately, but this has a modest impact on the performance of the UK equity market. It is certainly very difficult to get direct exposure.
Our strategy in this difficult environment has been to maintain a bias to traditional, well managed solid companies with strong franchises in their area of business and, where possible, with a positive free cash flow. This is classic fundamental analysis in the smaller companies area, and one which, we believe, will prove successful in the long run. These are perhaps not the most exciting companies in the market, but the volatility of some of these more exciting companies is more than we believe most investors would be prepared to tolerate. Careful stock selection, as ever, is proving key to performance in these times.In terms of strategy, we are looking to support services and construction and building materials in the main at the moment. Although housebuilders have come under some pressure, trading is buoyant and the prospect of merger and acquisition activity in the sector is helping to support valuations. Companies involved in Private Finance Initiative (PFI) work have also held up well, with strong order books and more favourable bidding arrangements.
At these valuation levels we are starting to find some highly attractive, well managed companies for the portfolio. One of the companies we are currently most positive on is high street fashion retailer French Connection. A strong brand and innovative marketing continue to drive stunning sales growth in the UK, while respected management keep a close eye on the bottom line. We believe this is a high quality company in what has been a difficult sector for smaller companies.
Another company we like is Carillion, a specialist in construction and services. The company competes strongly in the market for outsourced PFI work, with an established position in a number of areas and focus on larger projects where competition is weakening because of the substantial bid costs. As well as offering steady modest earnings growth for the next three to four years, these projects offer high long-term returns, subject of course to performance criteria. There is always the possibility of operational problems, which would hold back these returns.
However, this is a measurable risk which we are keeping a close eye on, and feel relatively more comfortable with this than the more unquantifiable risks in some other parts of the market at the moment. With valuations compelling at the moment with conservative accounting policies, we are happy to have this as one of our major active positions in the portfolio at the moment. Finally, we are taking a positive view on information management and communications group Communisis.
The group is expanding from its base in print management to encompass the whole life cycle of a document, from origination through to procurement and fulfilment. The company is also the UK leader in direct mail activity, with the buying power and cost advantages associated with that.
Again, the company is a beneficiary of growth in corporate outsourcing, which is relatively immune from the movements of the economy although there will always be an element of exposure to advertising cycles. With strong management and good free cash flow generation in a volume business we believe the return on capital for the group should continue to rise from here as the service arm of the business grows and the need for expensive capital equipment starts to decrease.
It has been a characteristic of the UK smaller companies market, with the low valuations we are currently seeing that the level of management buy-outs and trade purchases has increased. Two companies we held in the portfolio have recently been affected by this ' information technology specialist Azlan, and housebuilder Bett. This activity in itself helps to provide a floor for valuations, and suggests that we have to be coming close to the nadir for share price valuations.
The FTSE Small Cap Index is still trading at a 15% discount to the FTSE All-share Index, and it will take a recovery in confidence before smaller companies recover strongly from here. However, we are starting to find entrance into some excellent investment opportunities at very attractive valuation levels, and believe that investors prepared to take a long term view and keep the faith in smaller companies could well look forward to better times ahead, now that conditions have started to stabilise in the Middle East.
With uncertainty affecting consumer spending and the housing market, companies exposed to government spending look well-placed.
Valuation levels mean there are attractive and well-managed companies on the market.
Low valuations have led to an increase in the number of management buyouts.
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