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Small caps still beat giants despite rocky road ahead

The range of investments available among smaller companies, together with attractive valuations, has made the sector a good place to invest over the past five years.

Small caps still beat giants despite rocky road ahead

The performance of UK smaller companies has eclipsed that of their large cap compatriots in recent years. In the five years to 29 February 2016, the total returns from the FTSE Small Cap index (excluding investment trusts) stood at 70.8%, with the mid cap FTSE 250 close behind, at 69.4%. This dwarfed the 22.2% total returns from the giants of the FTSE 100 in the same period.

The party has been spoilt slightly in 2016, with the small cap index dropping by 1.5% so far this calendar year (to 8 March), while FTSE 100 total returns rose by 1.4%. But there is no denying that, despite recent bearish market conditions, UK small caps have been a good place to invest.

Weighty issues

Why has the smaller companies sector performed so well?

In part, it is due to the make-up of the FTSE 100. Richard Bullas, manager of the Franklin UK Smaller Companies fund, said: ‘In the FTSE 100, you find large weightings in oil and gas, mining and financials, which were weak in 2015. Small cap markets are lower weighted in those areas.’

However, the small cap sector is currently facing a challenge. David Taylor, manager of the PFS Chelverton UK Equity Growth fund, said although dividends and earnings were currently good in the small cap sector, it was hard for small caps to outperform with the EU referendum on the horizon. ‘That causes uncertainty, so people go for liquidity, meaning large caps and bond proxies,’ he said.

Range of opportunities

Nevertheless, investment opportunities remain in the small cap arena.

Gervais Williams, manager of the Miton UK Smaller Companies fund and Miton UK MicroCap Trust, said there was a much wider range of sectors among smaller companies, with more individual companies and a larger opportunity set. ‘The small cap end of the market offers the full range of potential,’ he said.

Bullas said small cap valuations looked attractive relative to the rest of the market. ‘The FTSE Small Cap is trading on a 15% discount to the wider market on a price-to-earnings basis,’ he said.

He said he had recently found good value in businesses that were down 15% to 20% compared with a month ago. ‘They will come through in much better shape in three to five years’ time,’ he said.

Dodging the duds

Laith Khalaf, senior analyst at Hargreaves Lansdown, said the small cap market was littered with companies that were ‘not very good’, but this opened up genuine stock-picking opportunities for astute fund managers.

‘For managers investing in that space, there are real prospects to outperform the index by avoiding the bad stuff,’ he said.

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