Are Small Cap Valuati
ons too Rich?
Before doing so, we’d be remiss not address the issue of small-cap and mid-cap valuations relative to historical standards. More specifically, small- and mid-cap UK equities have for some time now traded at a premium to large-caps. One way to see this is by looking at the forward P/E ratios for UK equity funds. The median P/E of all the funds in the Morningstar UK Large-Cap Value, Morningstar UK Large-Cap Blend and Morningstar UK Large-Cap Growth categories is 13.5. The P/E of the median fund in the Morningstar UK Small Cap category is 16.7. This is at odds with historic norms: Typically, large-caps command premiums to small caps. This is because they are usually financially sounder, higher quality businesses, and because they offer a level of liquidity that small caps cannot match. This isn’t to say that small-caps are due for a fall, but we have a difficult time justifying putting additional money to work in the area with valuations as they stand.
That said, Harry Nimmo’s Standard Life UK Smaller Companies continues to impress us. Nimmo and his team bring a wealth of small-cap experience to the table. They have also kept the fund reasonably well spread out across economic sectors, and individual issues. They are more willing to pay up for higher-growth companies than their typical rival, however, and that exposes the fund to additional valuation risk. Even so, they’ve shown an ability to make that risk pay and the fund has not been too much more volatile than its typical sector peer. We’d also note that the fund’s TER, at 1.54%, is quite reasonable relative to its peers’. We’re also well aware of Dan Nickols success over at Old Mutual UK Select Smaller Companies, but we just can’t abide by the firm’s recent decision to up its AMC to 1.75% from 1.50%. Yes, they capped the fund at 350 million units, but that does not curtail their ability to earn massive amounts of money off it without upping the management fee.
Meanwhile, in the Cellar . . .
On the flip side, there are some funds in the sector that just haven’t been able to pull it together. The most obvious example is Canlife UK Smaller Companies, run by Craig McDougall. The fund has returned just 4.3% annualised over the past three years, compared to a sector median of 22.7% annualised, and it doesn’t look much better over the past five years. Close Beacon Investment adds insult to injury, however, by charging a TER just north of 2% while delivering the worst five-year return in the sector, and the second worst three-year showing. We can’t imagine anyone is seriously considering either fund, but if so, consider yourself warned.
A version of this article previously appeared in Investment Adviser, Financial Times Ltd.
