Fleeing investors cause problems for small caps

Capital flight to blue chips will continue to hamper small and mid-cap performance in the short to medium term.

Large caps have been outperforming small caps over the calendar year to date, as risk averse investors flee to more liquid stocks. The prevailing negative market sentiment and lack of visibility of earnings will lead to continued underperformance from the asset class, says Alex Ross, UK small-cap fund manager at Aberdeen Asset Management.

He says: 'We are expecting continued underperformance from small caps in the short term, largely due to the lack of liquidity and quality and flight to blue chips.'

While P/Es across the small-cap spectrum have been beaten down by 18 months of falling markets, Ross is guarding against undue optimism.

He says: 'If you look at the P/E for our portfolio, it is on about eight times. I would usually call this a strong buy, but there is such a lack of visibility going forward that it really makes it difficult to assess valuations going forward.'

He believes the outlook for small caps remains negative, despite the falling interest rate environment. While reductions in interest rates usually herald a period of outperformance from smaller companies, the current exceptional market conditions reduce the likelihood of this in the short to medium term at least.

He says: 'Smaller companies are down 32% year to date and Aim is down 42%. They are on a significant discount to blue chips, but it is difficult to say they have actually reached a bottom.'

Andy Brough, UK fund manager at Schroders, is overweight small and mid caps and believes that the interest rate cuts have started to filter in some areas within the small-cap universe. Brough says housebuilders is one area to benefit from the cuts and the sector is trading on reasonable valuations. He adds that demand for new houses is exceeding supply, which is also buoying the sector.

Given the robustness of consumer and Government spending over the year to date, Brough says he prefers companies benefiting from public spending and business to consumer companies.

He says: 'I think those close to the consumer, such as retailers, are best positioned and many are trading on sub-10 P/Es. Government spending is also looking pretty good, but corporate spending is still not that much, so business to business is going to struggle.'

Paul Mumford, manager of the Cavendish Opportunities Fund, is even more bullish about the asset class. He is heavily overweight small and mid caps in anticipation of attractive growth and corporate action opportunities.

Mumford says: 'There is some good value out there. If you get a big markdown across the board, you can find some attractive valuations. It can lead to takeover opportunities and companies buying back their own shares.'

Property companies in particular are benefiting from the negative market sentiment, in that they can buy back swathes of their own shares at a discount to the net asset value.

Ross agrees that company buybacks of their own shares have been increasingly common and such actions can be viewed as confidence builders.

Mumford is also bullish about emerging pharmaceuticals companies, believing they are more likely to enjoy strong growth than their large-cap brethren.

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