The UK equity market delivered a positive return for the second year running, albeit a more modest p...
The UK equity market delivered a positive return for the second year running, albeit a more modest performance than in 2003. Smaller companies outperformed large caps again. The question now is whether small caps can deliver for a third year.
A close examination of the drivers of the small caps market's strength should shed some light not only on the reasons behind its outperformance but also highlight the potential for them to generate a positive return again 2005.
Perhaps the simplest explanation for the sector's strength is that smaller companies are naturally more attuned to the domestic economy than their larger peers, which tend to have a wider global reach so are more subject to the ebbs and flows of the world economy. And thanks to successive decreases in interest rates between 2000 and 2003, the UK's domestic economic environment has been remarkably buoyant at a time when most of its western counterparts, notably in mainland Europe, have been struggling to maintain even meagre rates of growth.
Smaller companies are inherently more dynamic than their larger counterparts and were able to adapt to the bursting of the dotcom bubble relatively rapidly. They made their balance sheets more robust, chiefly through stringent cost cuts, to all intents and purposes prompting a swift rebound in their potential to provide positive earnings surprise.
The combination of sustained positive trading conditions and cheap borrowing costs as a result of the lowest interest rates for a generation has enabled smaller companies to reward investors generously. Shareholder dividends from smaller companies have been on the up across the board, and more and more companies have instigated share buyback programmes, which reduce the number of shareholders, enabling the remaining shareholders to enjoy a larger proportion of future profits.
There has also been significant buying interest from within the sector itself, with directors increasing their stakes in their own companies in a clear demonstration of confidence in their businesses' prospects.
Other corporate activity has played a key role in the sector's positive fortunes, notably the spate of management buyouts and veritable tidal wave of M&A activity, including numerous bids from venture capitalists, highlighting the substantial value to be found in the sector.
This is borne out by the performance of the UK's most nimble companies, as represented by the FTSE Fledgling index, which has advanced 18% in the year to mid-December, a return second only to the FTSE Alternative Investment Market (Aim).
Aim was the best-performing UK index in 2004, a particularly noteworthy feat given that a record number of new firms have come to the market since the start of the year, soaking up liquidity. As a result, with some 1,000 companies, Aim now has more listed than the FTSE All-Share.
Arguably there is now the most abundant supply of small caps with impressive growth prospects than ever before. The supports for Aim are virtually indistinguishable from those of the traditional small cap indices - briskly-expanding companies with less debt, fewer pensions problems and limited dollar exposure than their larger counterparts.
Furthermore, liquidity levels in Aim are comparable with those of the main market. Value can be found on Aim, which is heavily weighted in some of the more attractive sectors, and the prospect of further issuance in the months ahead should reflect excellent opportunities.
Significantly, the UK equity market appears to be snapping back from the bias towards large cap stocks established in 2000 when fund managers headed for their relative safety following the detonation of the dotcom bubble.
Together with an increase in Venture Capital Trusts investing in Aim stocks this could prove to be a powerful support to smaller company valuations going forward.
Viewed in the context of an improving global economic backdrop, the stage appears set for UK smaller companies to reward investors once again in 2005.
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