Investor sentiment has improved recently following signs of economic recovery in the UK. While the UK market on the whole has performed well on the back of it, the major beneficiary of that optimism has been smaller companies. Some commentators have told FE Trustnet that the rally could be about to stutter, and investors should consider taking profits, but Hargreave says valuations are still attractive and the bull market is just beginning.
"Interestingly, the multiples of the small cap index are 13 times, which are roughly the same as the FTSE 100, while the FTSE 250 is closer to 14 times, so there is nothing really in it when it comes down to valuations," Hargreave explained.
"Another interesting point is that up to the last 12 months or so, there had previously been net monies coming out of small caps in every year since 1996. That appears to have stopped, which is encouraging."
Since the start of the year, the FTSE Small Cap index has returned 29.27 per cent while the FTSE 100 has returned 16.35 per cent.
Performance of indices year-to-date
Source: FE Analytics
However, as the graph shows, while the blue chip index has moved sideways since the May/June correction, the small cap index has gone from strength to strength.
One of the other reasons why Hargreave thinks small caps can continue to rally is because investors will continue to switch from bonds into equities in a development dubbed "the great rotation".
At the start of the year, many experts predicted that equities would outperform because they would capture inflows from disillusioned fixed income investors trying to get out of the overpriced bond market.
Whether this has actually happened yet is debatable. While equity funds have seen a lot of inflows, some market commentators say this is just more un-invested cash coming into the system instead of capital from the bond market.
Nevertheless, Hargreave says this switch is inevitable as interest rates will have to go up from here.
"I think that switch will continue. Interest rates will have to go up soon, especially when you look at recent house prices. So really, I think now is actually a very good time to be buying smaller companies," Hargreave said.
Rising interest rates could affect equity markets as well, of course.
John Leahy, who runs the five crown-rated Hermes UK Small and Mid Cap Companies fund, recently told FE Trustnet that the ultra-low interest rate environment has meant finding a stock’s fair value has become an increasingly difficult task.
The manager warned that if interest rates were to go up, it could drastically change certain stocks' long-term worth and therefore would catch many investors in a "value trap".
Hargreave admits that if interest rates were to spike then that would be dangerous for equity investors, but at the same time doesn’t expect them to rise too dramatically over the short- to medium-term.
"It all depends on how much they go up by. If they were to rise by 2 or 3 per cent, I don’t think it would have much of an impact," he added.
Nevertheless, the manager says that trying to predict interest rate volatility is a fruitless task and instead investors should realise that now is the time to be invested in the lower end of the UK market.
"Smaller companies will always grow faster than larger companies," he said. "We are enjoying a very good market here in the UK and so now is a great time to be buying AIM stocks, for instance," he added.
Hargreave is commonly regarded as one of the best UK small cap managers and is certainly one of the most experienced, having started his career in 1969. He has run the £692m Marlborough Special Situations fund since July 1998.
According to FE Analytics, over that time the fund is the best-performing portfolio in the IMA UK Smaller Companies sector, with returns of 1,501 per cent – more than five times the sector average.
Performance of fund vs sector since July 1998
Source: FE Analytics
The fund is a top-quartile performer over five and 10 years.
The FE Alpha Manager also runs the Marlborough Multi Cap Income and the Marlborough UK Micro Cap Growth funds, along with the closed-ended Hargreave Hale AIM VCT.
Hargreave is known for taking a highly diversified approach in his portfolios, because he wants to mitigate the inherent stock-specific risks that come with smaller companies. For instance, he has a hefty 239 holdings in his Marlborough Special Situations fund.
Hargreave’s largest individual position, TT Electronics – a FTSE Small Cap-listed company that manufactures components for the defence, aerospace and transportation sectors – makes up just 1.4 per cent of his fund.
The stock has had a very good year, according to FE Analytics data, returning 61.31 per cent to the index’s 46.92 per cent.
Performance of stock and index over 1yr
Source: FE Analytics
Marlborough Special Situations has an ongoing charges figure (OCF) of 1.53 per cent and requires a minimum investment of £1,000.