Small businesses are attractively valued relative to larger companies and often have stronger growth, so they should soon start to produce positive surprises
The history of investing in UK small caps has been a happy one. The London Business School, together with ABN Amro, has compiled data on their performance since 1955, which shows that UK smaller companies have outperformed compared to the wider market.
For instance, the Hoare Govett Smaller Companies Index (HGSC Index), which measures the performance of the lowest 10th by market capitalisation of the main UK equity market, increased at an annualised rate of 15.7% over the 48 years to end 2002.
The chart on the right sets out the distribution of annual size returns by deducting the return of the All-Share Index from the return on the HGSC Index in each year since 1955. A sum £1,000 invested at the start of 1955 in stocks comprising the HGSC Index would have been worth £1.1m, on a total return basis, at the end of 2002. A comparable investment in stocks comprising the All-Share Index would be worth £290,000. If inflation is stripped out, the £1,000 investment in stocks comprising the HGSC still rises to £64,823.
These long-term rates of return are clearly attractive, but the medium term record for smaller companies has been a little less impressive. Since the start of 1990 the HGSC Index has outperformed the All-Share Index in only five of the 13 years. During the recession of the early 1990s small caps suffered, but they outperformed in 1993 and 1994 as the UK economy recovered. With the UK economy weakening in 2001 and 2002, the HGSC Index has underperformed the All-Share, but as the economy strengthens, can we expect smaller companies to outperform again?
To help us answer this question it is worth looking at the composition of the small cap universe. It is diverse, much more so than the wider market which is dominated by oils, pharmaceuticals, banks and telecoms. Cyclical Services and Cyclical Consumer Goods comprise 32% of the small cap universe as measured by the HGSC Index, but only 14% of the wider market as measured by the All-Share Index. On a similar basis, Basic Industries and General Industrials comprise 16% of the small cap universe but only 5% of the wider market.
Taking this structural bias into consideration, it is quite reasonable to expect small caps to outperform more defensive larger companies as the UK economy strengthens, much as they did in the mid 1990s, and, more markedly, during the mid and late 1980s.
So what should investors be looking for in small caps? Certainly strong management is critical. It is hard to judge this without sitting down with management face-to-face and talking through the mechanics of their business, and their aspirations for it.
We try to understand management's priorities for the business they run, and assess how appropriate these are. As far as the businesses are concerned, we prefer to invest in companies operating in markets where there is some growth ' it is difficult to perform strongly in declining markets. We like small caps which have real influence in their markets; generally this means a top three market position. A good market position is of less value without barriers to protect it.
The sustainable barriers to competition we identify are brands, technology or know-how, major capex required by competition, and interdependence with customers, but there are others. Many small companies meet these criteria, and these are the companies we like to monitor and invest in.
An attractive operating environment needs to be combined with the right financial characteristics. Achievement of good historic earnings growth, and an assessment that this is likely to continue, is important. We also like to see profits being turned into cash, and companies achieving good cash returns on their investments.
It is not uncommon to find companies with good records of profits and earnings growth, but dig deeper and debt levels may be rising, growth has come largely from acquisitions, and returns may actually be thin. These are companies to be wary of.
While picking the right companies is critical, it helps to look in sectors that are favourably placed. At present, the sectors to which we are most attracted are insurance, speciality and other finance, and construction and building materials. The Lloyds insurers are well represented among UK small caps. All have talked about the strong rating environment in recent months, something confirmed, of course, by the companies having to pay the higher premiums.
Insurers have also experienced low levels of claims in 2002 and the first quarter of 2003. This has allowed the underwriting companies to achieve good profits in 2002, a trend which should continue into 2003. Many are very attractively valued on single figure 2002 earnings multiples, which should fall further in 2003.
They are valued on modest premia to net tangible assets, and some have good dividend yields. Of course there are uncertainties; the strength of re-insurers, levelling off of rates in certain niche areas, and the need in some cases to strengthen prior year reserves; but these are reflected in current valuations.
Within the small-cap speciality finance area, there are a number of fast growing niche lenders which compete well against large cap competitors trading on more than twice the ratings. The small cap construction sector includes many housebuilders, many of which are trading well and remain lowly valued in terms of both earnings and assets.
The sector also includes a number of leading suppliers of home improvement products such as Ultraframe, (conservatory roofing systems), and Marshalls (patio/ driveway stone) which may fare better in a less active housing market although they are exposed to any significant downturn in consumer spending. These are attractively valued on forecast earnings multiples of nine to 11 and each is very soundly financed.
As confidence rebuilds we expect to see a lot more acquisition activity within the small cap universe. Over the last few weeks we have seen signs of this already with bids for Selfridges, Fitness First and Scottish housebuilder Bett. As larger companies seek sources of growth and private equity houses invest the funds they have raised, we will see much more.
Private equity houses will generally need to complete multiple acquisitions to achieve synergy benefits, and in so doing can help to restructure sectors. Small companies are currently attractively valued in absolute terms and in many cases they have very good growth opportunities. Yet they trade at a discount to larger, often lower growth companies.
Throughout much of the 1980s, and in the mid 1990s, small companies traded at a premium to the wider market. In fact, small companies have tended to trade at a premium during periods of economic recovery. Over the past seven years, small companies have traded at a fairly wide discount. This is not really surprising. Smaller company shares are more difficult to buy and sell and are more exposed at the margin if trading conditions are weak. Price falls after profit warnings can be severe.
However, this can work in both directions, and we are now closer to the time when smaller companies will produce positive surprises. Perhaps small companies will again revert to trading at a premium to the wider market as economic recovery comes through over the next few years.
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