After a strong 2004, the UK smaller companies sector is expected to be sluggish for the next year, a...
After a strong 2004, the UK smaller companies sector is expected to be sluggish for the next year, according to fund managers. Any movement that there is will come from two main drivers: private equity investment and earnings growth.
Neil Hermon, head of pan-European smaller companies, Henderson Global Investors, says: "Smaller companies have had a phenomenal year up until the end of 2004. However, for 2005 it has gone flat. We expect this to continue as higher commodity prices and rising interest rates slow earnings growth."
According to Hermon, the valuation gap has closed between small and large-cap stocks. The key factor for the future outlook of the sector will be whether or not private equity players will continue to buy up smaller players in the market place.
Hermon thinks private equity will continue to be the main driver behind the smaller companies market as consumer spending is slowing down in the UK. Interest rates have increased and he expects difficult times ahead for the consumer.
"We are avoiding companies that could be impacted by the slowdown in consumer spending as investing in these types of companies could lead to a negative earnings surprise," says Hermon.
James Thorne, investment manager at Barings, is also cautious about smaller companies that are heavily reliant on consumer spending for growth.
Although Thorne warns against companies that may be impacted by the slowdown in consumer spending, he feels there are still some opportunities to be found.
Thorne has been targeting companies that cater for parts of the UK demography that have not been impacted in the slowdown in consumer spending. He feels the over-45 group are the most protected as they have paid off their mortgage and will be more resilient to the downturn. He has invested in companies such as Wyevale Garden Centre as he believes it could be a beneficiary of their spending.
According to Thorne, smaller companies will still outperform larger companies this year.
"If you look at the earnings growth of smaller companies versus large caps they have significantly higher earnings potential than their counterparts."
Thorne thinks smaller companies can benefit from being niche players in a low inflation environment. He says: "We believe earnings growth will be the main driver of performance behind the smaller companies market."
Thorne feels that M&A activity will help smaller companies, but says private equity investment will only help at the higher end of the small-cap market. Although it will help these companies consolidate and strengthen, he would not rely on venture capital as being a more important driver behind the smaller companies market than earnings growth.
One area in the small-cap market that Hermon and Thorne both agree will do well is companies that benefit from public spending.
Currently, Hermon favours construction companies as he believes the government will continue to invest in areas such as hospitals, schools, prisons and roads. He feels valuations are reasonable in the construction industry and these types of companies will have better-than-expected earnings growth.
According to Thorne, although there are concerns about the election, the government will be committed to long-term spending in social housing. For example, it is expected local authorities will outsource maintenance and management of social housing as well as garbage collection, road maintenance and street furniture. Thorne has aligned his portfolio towards these types of stocks.
Thorne also thinks environmental legislation will help small companies in this sector. The government has committed to the Kyoto treaty to cut down the issuance of greenhouse gases in the UK and to reduce the amount of CO2 emissions. An example of a beneficiary of this will be vehicle manufacture Azure Dynamics, which is creating a hybrid vehicle that combines electric and internal combustion drives for greater efficiency and convenience. For the long term, Thorne also likes the aerospace sector.
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