Small-cap stocks sold off aggressively in March and over the second quarter after Federal Reserve chair Janet Yellen spooked the markets by hinting that interest rates could start to rise sooner than expected.The £1.2bn Standard Life Investments UK Smaller Companies fund was hit harder than its peer group during this time.
FE Analytics shows the fund dropped 10.67 per cent over the second quarter against a fall of 5.02 per cent for the average IMA UK Smaller Companies member.
Nimmo said: “The question that needs to be answered is ‘what the devil’s going on?’ This is a very unusual period for markets and a very unusual period for our fund.”
Performance of fund vs sector over H1
Source: FE Analytics
The manager says Yellen’s comments sparked a “strong and swift” rotation by hedge funds, multi-asset funds and all-share mandates away from areas perceived to be higher risk such as small caps – which they often take exposure to through ETFs or derivatives.
“Selling activity [in ETFs or derivatives] can drive down the whole FTSE 250 index, in particular the stocks at the bottom end of that index,” he explained.
“In our top 10 holdings, the bulk of our stocks are FTSE 250 companies. We saw these stocks affected quite dramatically over this period.”
Furthermore, the large number of stock market flotations – many of which were in the retail sector through the likes of Poundland and Card Factory – in the opening half of 2014 had a negative impact on small caps.
Participating in new issues often sees funds dip into cash that would have gone to existing holdings or even sell down current positions.
“All of this meant that our stock selection matrix went into reverse in that period over the second quarter,” the manager said.
Nimmo’s momentum-based process places high regard on stocks with positive earnings prospects, rather than being overly focused on valuations.
However, the recent past has seen stocks with positive earnings momentum underperform, while those with low price/earnings ratios and high dividend yields have outperformed.
“Over the long term, valuation is a secondary factor, it’s less predictive of share prices going forward. Share prices generally reflect earnings prospects and in particular improving earnings prospects,” he said.
“But if you look over the short term, this position has been reversed. What’s working over the short term is valuation pure and simple, whereas earnings revisions are doing the opposite. We see that as a short-term scenario that will revert to normal.”
Standard Life Investments UK Smaller Companies’ holdings that saw positive earnings changes but share price falls over the second quarter include multi-utility supplier Telecom Plus, online real estate portal Rightmove and fashion retailer Supergroup.
“This is quite an unusual situation. It represents a major market over-reaction and mis-match, a dislocation between earnings prospects and share prices,” Nimmo added.
However, the manager notes that this mis-match appears to be easing in the second half of the year.
During July, 15 of his holdings published their results and 13 of these posted in-line or better results, which has broadly been met with positive share price movements.
“We think we’re starting to see an end of this second-quarter effect, this dramatic mis-match between earnings prospects and share price performance.”
The past three years have been tough for the fund; it has fallen short of the sector average by 20 percentage points with a return of 37.25 per cent.
It was also included on the latest Spot the Dog report by Bestinvest for the first time in its history.
Performance of fund vs sector over 3yrs
Source: FE Analytics
But the manager is confident in the portfolio as it stands, having disposed of holdings such as ASOS, ITE, Rightmove, VitecGroup and Dialight while adding positions in Grainger, Brammer, Cambian Group, Secure Trust Bank and FDM Group.
“I’m actually very pleased with the shape of the portfolio. We seeing companies that in the main have traded off in share price terms. Many are paying proper dividends and growing them quite quickly. Valuations tend to be at or higher than the market, but this reflects the prospects for these companies.”
The fund has a P/E of 17.6, higher than the Numis Smaller Companies index’s 13.9 but is expected given the manager’s momentum style.
Its yield is slightly lower than the index’s at 2.4 per cent but forecast dividend growth is 15.4 per cent - compared with 9.3 per cent for the benchmark.
Despite the short-term underperformance, the Standard Life Investments UK Smaller Companies fund has a strong longer-term track record.
Over 10 years to 6 August, it has returned 305.01 per cent against a sector average of 181.44 per cent.
Its five-year return is 134.45 per cent, compared with the 123.86 per cent average return of its peers.
Performance of fund vs sector over 10yrs
Source: FE Analytics
However, Nimmo concedes that small caps have had strong run in recent years but says investors should ready themselves for more muted returns going forward.
“The nub of it is we don’t think returns in 2014 and 2015 will be as good as in 2012 and 2013. Indeed, the last five years of returns in smaller companies have been spectacularly good - on average, the Numis Smaller Companies index was up significantly over 20 per cent per annum in the period up to March 2013,” he said.
“I think in the next five years that number will be closer to 10 per cent annualised returns, maybe even slightly lower.”
Standard Life Investments UK Smaller Companies has an clean ongoing charges figure of 0.99 per cent.
