Morningstar defines UK small cap equities as those in the bottom 10% of the market-capitalisation. We have emphasised in previous articles that the valuations of small (and mid-cap) offerings appear rich relative to historical norms. To recap, in the last few years, small caps have been commanding premiums to large caps, which
is at odds with historical norms. More recently, the trend still holds but the spread is narrowing: the P/E ratio of the median fund in the small cap category is 15.02, compared to 13.18 for the median large cap fund as of 31 October 2007. Earlier in the year the difference was over 300bps. The recent large cap outperformance can predominantly be attributed to the inevitable flight for quality on the back of recent uncertainties in the credit markets. Investors are seeking a smoother ride on recent events through targeting the bigger firms which are typically more financially sound and offer greater liquidity than smaller firms.
A couple of key features have differentiated funds in the UK Small-Cap Equity category. The recent poor performance of the Alternative Investments Market (AIM) in the aftermath of the credit crisis has hurt funds with large portions of their portfolio invested there. As smaller companies trading on AIM have a lower volume of traded shares, the losses incurred during the credit crisis were amplified as liquidity in these stocks dried up. Rathbone’s Special Situations Fund exemplifies this issue well. It lost 9.34% over the 6 months to 31 October as its high AIM exposure backfired. Despite its experienced management, the high volatility of this fund (and others with similar AIM exposures) makes it hard to stomach for most mainstream investors -- an aspect the manager has recognised and is taking steps to try to avoid a repeat in the future.
On the flip side, a common theme with many of the top performers has been large exposure to micro-caps and/or the energy and industrial materials sectors as a boom in commodity prices has driven those sectors sharply higher. A top performer both year-to-date and over the last five years is the Marlborough Special Situations Fund. Thanks to its experienced skipper Giles Hargreave, it has scored big on names in-line with its higher than average growth tilt and higher than average micro-cap exposure, while keeping a lower financials weighting than its peers has helped during the recent sell-off. Investors should expect a bumpy ride here though as this aggressive fund is more volatile than its average peer.
A steadier offering that earns our tick of approval is Invesco Perpetual’s UK Smaller Companies Equity Fund. This is a long term top-quartile performer with an experienced manager who has delivered 24.9% per annum over the last three years. Portfolio manager Richard Smith adopts a cautious and disciplined approach suitable for the less daring investor (click here for our take on this fund), an approach we think has merit in what is a volatile sector.
