Gervais Williams, head of Gartmore's smaller companies fund management team, says cashflow, low gearing, a suitable inflationary environment and general market resistance to smaller firms are combining to create a hugely positive outlook for the sector
A key indicator of the optimism in the sector is the number of new issues, he says.
There have been some 85 issues so far this year, including 16 in June alone - about 80 have been on the Alternative Investment Market.
A number of existing firms, such as Corus the steel maker – which has made its way out of the small caps because of its share price recovery - and Baggerbridge Brick are benefiting from strong pricing power in the current market.
Their ability to increase prices stems partly from under-investment and a protracted process of mergers and acquisitions over the past 15 years.
That in turn means suppliers of goods are able to leverage significant profits from the current global economic recovery because demand has risen sharply compared to production capacity enabling companies to set higher prices.
Where smaller companies have invested in capital to become more efficient, they have often done so without recourse to borrowing from banks or through issues of equity – both have been extremely hard to do for many smaller firms in the past few years.
Having had to self-fund investment, this means these companies do not carry debt on their books, which means extra profits now earned can flow straight through to the bottom line rather than be diminished by interest payments to creditors.
Share prices in smaller companies are currently more volatile than those in the large cap universe, Williams adds, which offers more chance for investors to gain from any upside, rather than seeing the value of shares slide sideways over a considerable period time.
Many investors are "jumpy" at present, which means they are more likely to take short term profits then go back into the market again to try for additional profits.
"We're in a stage of double-guessing, so people revisit their investment decisions," Williams says.
Williams says he is not looking for another Sage or Microsoft – although he once did hold Sage shares – because the funds he oversees are not looking to take on the risk of trying to identify what may be a single company out of many that might one day turn into one of the larger big caps. The point is to make money out of small cap firms whose share prices are going up and down, and not look for that one big bet.
In terms of sub-sectors, Williams says he is looking more at manufacturing than services or retail, which he feels may have run their course for the time being.
With interest rates heading higher in both the UK – and, soon possibly the US - there may be some fear on the part of investors who feel small caps traditionally fare less well in higher interest rate environments.
Williams dismisses such fears, by stating his own view is a bout of inflation would be good for both economies in helping to reduce levels of debt.
Investors' fears about smaller companies in general means they are likely to miss out on good values, Williams suggests.
And for those investors who are really worried about the state of equity markets, past history suggests smaller listed companies see their share prices rebound stronger than bigger ones at times of terrorist or similar acts.
Gartmore’s £54m Smaller Companies investment trust currently trades on a share price discount to net asset value of about 19%.IFAonline
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