Corporate activity is picking up among UK small and mid-cap companies, suggesting the sector is unde...
Corporate activity is picking up among UK small and mid-cap companies, suggesting the sector is undervalued, in the eyes of Richard Smith, manager of the Invesco Perpetual UK Smaller Companies Equity fund.
The pick-up in merger activity, according to Smith, is because small companies are currently trading at a 20%-30% discount to large firms on a P/E basis.
Smith says these stocks, as measured by the FTSE Small Cap Index, currently have an average free cashflow yield of 12.5%, which represents not only a high absolute yield but one that makes many firms attractive for buyout activity.
He adds: 'The difficulty with markets at present is where are the buyers? Individual investors have become cautious, while the pensions and life assurance companies will be slow to become large investors. As such, corporates themselves will be the most likely buyers of equities.'
Kenny Watson, UK smaller companies investment manager at Britannic Asset Management, says the past six weeks has seen tangible evidence of a pick-up in corporate activity in the sector.
This activity is being driven by venture capitalists and corporate buyers and is providing support to valuations in the sector. Added to this, Watson says, the results season for smaller firms has been better than expected.
The military action in Iraq led some analysts to fear the worst but corporate results have continued to be either in line with or ahead of expectations, he adds.
Smaller caps lagged in March, failing to catch the FTSE 100 relief rally that took place following what appeared to be a successful outcome of the war with Iraq, although improvement is expected in coming months., Watson notes.
While the pick-up in corporate activity has provided a boost to the sector, Smith feels much of it has come from the venture capitalists, which can be slow-moving in terms of asset allocation. As an example, he gives a takeover of Pizza Express first mooted in September last year but which has still to come to a conclusion. As a result of such immobility, the shares generally go dormant and there is no way of redeploying funds in the meantime, he says.
Smith sees the main threats to the sector as rising National Insurance Contribution (NIC) and general insurance costs, as well as rising commodity prices and wage inflation outstripping price inflation.
Watson says while consumer spending will likely slow as a result of increases in NIC and council tax announced in the April budget, he does not expect it to fall off a cliff.
Simon Bailey, director of smaller firms at M&G Investments, says increases in NIC and council tax will hit retailers but this is already largely reflected in their earnings numbers.
In the medium term, Bailey views smaller companies as an attractive area for investment. He says a number of companies in the sector are available at attractive valuations, all of which have quality management, high barriers to entry and decent track records.
While the economy is expected to remain slow and consumer spending weak, Bailey says this should not be seen as a disaster. He points out it comes on the back of unparalleled consumer expenditure fuelled by low interest rates, while market expectations are becoming more realistic.
Increase in corporate activity.
Results season better than expected.
Small-cap index expected to rebound.
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