UK markets have rallied strongly over the last two years, led by a surge in performance from small and medium sized companies. However, Beal (pictured) says the rally has brought prices up significantly and he doesn’t hold hope for the companies further down the market cap spectrum to continue their surge.
“When [smaller companies] are at a premium to the market, it is harder for them to deliver outperformance,” he said. “They aren’t cheap, the market is fairly fully valued.”
The manager says investors have also ignored the global shift that smaller companies, particularly in the UK, have taken over the last several years. While many investors have preferred them for their domestic exposure and general insulation from wider macro events, Beal says this is often not the case.
“Small caps are not just a proxy for the UK economy, they are now much more international,” he said.
Beal adds that valuations for the majority of companies in the UK – not just small caps - are at a level where companies need to deliver on earnings in order for growth to continue coming through.
“It’s difficult to see the level of sales growth coming through that is anticipated,” he said.
“We have a much longer list of things to sell than things to buy. We don’t want to buy things at these prices.”
Beal, who also runs the Shires Income trust, adds that dividends have been growing faster than the economic recovery, something that he doesn’t think is sustainable.
“To expect another year of double digit dividend growth would be optimistic, but I would have said that last year and I would have been wrong,” he admits.
While the manager doesn’t see a dividend contraction, he does expect a potential slowdown in dividend growth.
However, Beal doesn’t think that’s a bad thing. He says he would rather see companies invest in their own businesses and be flexible with their balance sheets in order to deliver the required growth in earnings down the line.
Small caps have “blow away” larger companies since 2009, in Beal’s words, which he says was the first big collective sigh of relief from the market after the credit crunch the year before.
Over the last five years, the FTSE Small Cap index outperformed both the FTSE All Share and the blue-chip FTSE 100 index, picking up 170.47 per cent, according to FE Analytics.
Performance of indices over 5yrs
Source: FE Analytics
The manager says investors with a long enough time horizon – three to five years – will likely come out winners by picking the right smaller companies.
He and the team at Aberdeen stick to a strict bottom-up process, which he says will underperform in rapidly rising markets, but has held up over the long term.
“One guarantee – there will be periods where we underperform, but you should hold our feet to the fire if we underperform when markets are down,” he said.
“We will underperform when markets are frothy, but definitely expect us to outperform in difficult markets.”
That has certainly been the case for the Dunedin Smaller Companies IT, which Beal has been running since 2005.
The trust did fall in the crisis year of 2008, but not as far as its peers or the FTSE Small Cap ex IT index. The same was true in the down markets of 2011, when the trust fell 8.83 per cent. Its benchmark shed 15.16 per cent that year.
Since Beal took the helm in December 2005, the trust is up 171.24 per cent. The IT UK Smaller Companies sector gained 158.13 per cent while the FTSE Small Cap ex IT index gained just 70.13 per cent.
Performance of trust vs sector and index since 2005
Source: FE Analytics
The trust is trading on a discount of 7 per cent, so investors can pick it up for less than the value of its underlying assets.
It has been trading on an average discount of 4.04 per cent over the last 12 months and 6.85 per cent over the last three years, so the current discount is one of the cheapest points investors will have been able to buy in.
It has a dividend yield of 2.4 per cent and ongoing charges of 0.82 per cent.
Beal says the first, and key, step to deciding whether to buy a stock is to define the quality. Considering valuation comes last, he says.
“It doesn’t matter how cheap a company appears, we won’t buy it if it doesn’t match our quality criteria,” he said.
There are five key components they look for when defining the quality of a stock.
First whether they like the quality of the management team, secondly understanding business models and when they are likely to perform well.
The third feature is pricing power and the fourth elements of after sales or recurring revenues.
The team also look to be able to explain what the business does and how it generates returns
To the final point, Beal highlights investment banks as an example of a company they would steer clear of.
“If you catch it on the up, great, but once a cycle they’re going to blow their feet off,” he said.
Beal adds that companies need to have a balance sheet that gives them the confidence it is able to survive through the cycle. However, he says that doesn’t necessarily mean the company can’t have any debt.
“There are certain businesses that can handle a level of debt,” he said, “but sometimes companies need to have net cash. A balance sheet that’s appropriate to the business model, that’s a dealbreaker for us.”
Currently the highest sector weighting in the Dunedin Smaller Companies portfolio is industrials, with companies like RPC Group – the world’s leading suppliers of plastics packaging products and containers – and European textile services business Berendsen featuring in the top 10.
Though Beal said the team are coming up with very few ideas to buy in the current market, the trust holds just 1.3 per cent in cash because they believe it is their responsibility to be fully invested.
