Increasing investor confidence has seen the FTSE Small Cap and FTSE 250 indices surge ahead over the last 12 months, with both returning more than 30 per cent over the period.
Performance of indices over 1yr
Source: FE Analytics
While Taylor (pictured) – who manages the five crown-rated Chelverton UK Equity Income fund – is still confident UK small and mid caps can continue to outperform over the long-term, he expects a period of consolidation over the next few months.
"We can still buy the stocks we want at the moment, but what I will say and what is very important is that there is likely to be a lid on valuations over the next six months or so," Taylor said.
The manager adds that the main cause of this will be the huge amount of IPOs and new issuances, meaning now may not be the best time to buy into the market.
"Since the crash of 2008 there hasn’t been a lot of equity issuance. However, what has happened is that because we have seen a bit of confidence in the market, there has been this wall of issuance and IPOs recently," he added.
"After four, five, six months of that, it will pin down valuations."
"While small and mid caps have had a good run, the new issues and IPOs will provide a natural lid as investors who want to buy into them will have to take money out of their existing holdings," Taylor added.
His thoughts on the UK market are similar to those of Hermes’ John Leahy and Smith & Williamson’s Tineke Frikkee.
Leahy recently told FE Trustnet that he was concerned about valuations in the UK small and mid cap market, because with interest rates so low, investors are looking to deploy their capital as fast as possible.
He pointed to the recent flotation of Foxtons, the London-based real estate firm, which was seven times over-subscribed. This, Leahy said, should be taken as a warning sign that a correction is on the way.
Likewise, Frikkee says she has built up her cash weighting due to the flotation of the likes of Foxtons as well as the placing of Lloyds and Direct Line shares.
"When there are lots of sellers around, it makes me nervous. I much prefer to be holding back at times like this," Frikkee said.
Taylor has managed the £165m Chelverton UK Equity Income fund with David Horner since its launch in December 2006.
Our data shows that it is the second-best performing fund in the IMA UK Equity Income sector over five years, with returns of 160.66 per cent, beating its FTSE All Share benchmark by almost 60 percentage points.
Performance of fund vs sector and index over 5yrs
Source: FE Analytics
It is also the second-best performing fund in the sector over three years and is the best performer over the last 12 months.
Taylor says that relative outperformance stems from his and Horner’s investment approach.
"We are categorically an income fund and we find that income from UK small and mid caps," he said.
"The likes of Unicorn UK Income, Giles Hargreave and Gervais Williams are doing a similar thing and have performed well. However, the difference with this fund is that it doesn’t invest in any FTSE 100 stocks," he added.
Chelverton UK Equity Income has a yield of 4.25 per cent, with the managers using a yield screen to find and choose the companies they want to invest in, as Taylor explains: "We only buy stocks that have a 4 per cent prospective one-year yield."
"If you think about it, I could give you a yield of 4 per cent by buying a boring old life insurer that yields 8 per cent and a growth company that doesn’t pay a dividend."
"Everything in our fund must yield 4 per cent. These are companies that are cash-generative, have a decent balance sheet and therefore should offer a growing dividend. We call them dull but worthy companies, so this isn’t a sexy fund so to speak."
Taylor sells stocks when their yields fall to 2 per cent and then will re-invest the cash so that he and Horner can capture the long-term outperformance of value small and mid caps.
Chelverton UK Equity Income is made up of more than 80 holdings, because Taylor says he does not want to take stock-specific risks. Nevertheless, most of the fund’s holdings are equally weighted.
For example, the fund’s largest holding at the moment is Galliford Try which makes up just 1.9 per cent of its assets.
The fund has an ongoing charges figure (OCF) of 1.88 per cent and requires a minimum investment of £1,000.
Tomorrow, FE Trustnet will look at some other multi-cap UK Equity Income funds available to investors.
