Morningstar's "Perspectives" series features investment insights from third-party contributors. Here, the Association of Investment Companies asks UK Smaller Companies: Why Has Sector Held Up So Well and What is the Outlook?
The UK Smaller Companies sector has outperformed the average investment company over one, three, five and 10 years. Interestingly, whilst the average investment company discount has widened in the recent volatility, the UK Smaller Company sector held up well and has moved in slightly from a double digit discount of 10% as at end of July 2015, to 9% as at 12 October 2015. Why have UK Smaller Companies held up so well and what is the outlook for the sector?
Smaller caps have performed well in recent years, although returns may not quite match that for the next five years
The AIC hosted a press roundtable on the UK Smaller Companies sector with Stuart Widdowson, Manager of Strategic Equity Capital and Harry Nimmo, Manager of Standard Life UK Smaller Companies. The managers’ views have been collated, along with those of Jonathan Brown, Manager of Invesco Perpetual UK Smaller Companies and Gervais Williams, Manager of the Miton UK MicroCap Trust.
Stuart Widdowson, Manager of Strategic Equity Capital said: “Genuine smaller caps have performed well in recent years, and although returns may not quite match that for the next 3-5 years, there are plenty of reasons to be optimistic. Value can be found if you are willing to look for it, particularly if you can engage with the company’s management to help unlock it. We also see some interesting opportunities in momentum plays ‘gone awry’ that have been overly downgraded but whose base case remains attractive.
“There also remain a few opportunities among higher quality, higher margin businesses some of which have fallen out of favour, although valuations are not uniformly attractive. We also favour structural growth/themes for new investments rather than cyclical growth or recovery, and avoid companies with poison pills, such as DB pension deficits; blocking shareholders, which could frustrate or fetter M&A activity. Overall, low double digit growth is possible, provided that earnings forecasts are achieved.”
Harry Nimmo, Manager of Standard Life UK Smaller Companies said: “Smaller company equities represent a good place for investors interested in capital growth over the long term. The major academic studies on long-term smaller company performance by those such as Ibbotson, Dimson & Marsh, are testament to the power of the “Smaller Company effect” globally. In a fast changing world smaller companies can adapt more quickly to new and disruptive ways of doing business. What is more, these smaller companies are generally less well researched than their larger brethren, which itself provides opportunities for the diligent researcher.
“Experience and a solid investment process, which has been tested through several economic cycles, does count in the world of smaller companies. Larger companies in their turn have been found wanting in terms of their ability to grow and adapt to changing market conditions. Going forward, smaller companies’ greater exposure to the comparative safe haven of the UK economy in an uncertain world feels right. Their greater prospects for profits and dividend growth suggests that the long-term outlook for smaller companies remains robust.”
Jonathan Brown, Manager at Invesco Perpetual UK Smaller Companies Investment Trust plc said: “One of the major attractions of investing in UK smaller companies is that you can find companies that can continue to show good growth largely irrespective of economic conditions. The drivers of this growth include technological trends, structural changes and rolling out successful concepts. The performance of larger companies is conversely much more dependent on global and country related factors.
“UK smaller companies have much greater exposure to the UK economy, with larger weightings to domestic biased sectors including retailers, pubs and restaurants and house builders. The UK economy has been one of the fastest growing global economies in 2015 with that growth helped by rising levels of employment, low inflation and rising wages.
"The UK consumer is feeling more confident, encouraged by rising household cash flow and should continue to help drive economic growth in 2016. We believe UK smaller companies remain relatively attractive, particularly in the context of current global uncertainties.”
Gervais Williams, Manager of the Diverse Income Trust and Miton UK MicroCap Trust said: “With world growth under pressure it appears that dividend growth is becoming more patchy. Therefore we believe there will be growing interest in widening portfolio holdings to include more small and micro-cap holdings.
"Not only does this diversify stock specific and sector risk, but it also offers scope to participate in a universe of stocks with greater growth potential. We believe these factors could drive the outperformance of small and micro stocks substantially over the coming years.”
