Small-cap stocks have become more appealing than mid-caps based on valuations and imminent volatility in markets, according to FE Alpha Manager Alex Savvides, who runs the JOHCM UK Dynamic fund, and other UK equity managers.
Mid-caps have had a strong run over the six years since the equity market bottomed out after the worst of the financial crisis and have outperformed both their smaller and larger-cap counterparts.
According to FE Analytics, over the past six years the FTSE 250 is up 195. 46 per cent while the FTSE Small Cap index and FTSE 100 gained 169.18 per cent and 122.09 per cent respectively.
Performance of indices over 6yrs
Source: FE Analytics
This trend does not appear to be ending yet with 2015 seeing a strong start in the mid-cap space, as the FTSE 250 is ahead of the rest of the market, as shown below.
Performance of indices in 2015
Source: FE Analytics
Savvides, speaking at the FE UK Growth event early this week, said he is expecting smaller cap stocks to see a huge boost in the coming years while believing mid-caps to be expensive.
Savvides manages the £300m JOHCM UK Dynamic fund, which sits in the IA UK All Companies sector and has been mostly split evenly across large, mid, small and AIM stocks since Savvides took over the fund at the height of financial crisis in June 2008.
His value orientated strategy, which generally ignores cap size, has paid off with the fund returning 131.5 per cent over his time on the portfolio, almost double the IA UK All Companies sector average and significantly more than the FTSE All Share.
It has been a top quartile performer in the highly competitive sector over three and five years and is top decile since the fund’s launch.
Performance of fund, sector and index since 2008
Source: FE Analytics
“This fund has been going through a renewal period. The stocks that drive the fund forward over the next two years will be very different to the stocks that drove it forward over the previous two years. Small-caps have fallen out of the bottom end [of the market] in the last 15 months and there is some value in small-cap stocks that is not typically there,” he said.
“There has been a divergence and we have been responding to it. This is quite important for anyone who owns the fund.”
“Since the first time in the fund's history, the combination of our small-cap and AIM holdings will be higher than our FTSE 250 holdings. This is an important moment because while we have derived lots of value from our mid-cap holdings and our small and mega have flat-lined for a while that is about to change.”
Savvides says he is not sure how his new tilt toward smaller companies will continue but he is likely to make a further move away from mid-caps rather than mega caps.
He says the recent move has been also prompted by a belief that the UK equity market is set for a stretch of greater volatility and an increasing divergence in the performance of its individual companies.
“If you look at average P/E, the FTSE [All Share] doesn't look particularly cheap, but what is interesting is the divergence in P/E,” he said.
“There is much deeper divergence in performance in sectors and stocks that I hope as an active manager I can benefit from. There is a shift in thinking. There are huge bouts of volatility that we are benefiting from.”
Savvides says that one such example is the basic materials sector, explaining: “We have gone from having a massive underweight to basic materials to having an overweight.”
Other notable managers have also been looking more at the small-cap space.
Invesco Perpetual head of UK equities Mark Barnett has just passed one year as manager of the Invesco Perpetual Income and High Income funds – collectively more than £20bn of assets – over which time he has been upping the funds' small-cap exposure.
On the £71m Montanaro UK Equity Income fund’s latest factsheet, Charles Montanaro – manager of the fund – also expressed a bullish sentiment for small-caps.
“On the one hand a robust domestic economy, on the other the potential for political instability both at home and abroad. The contrasting back drop is reflected at the asset class level, where over the last year small-caps has underperformed large cap by 6 per cent. Strikingly, this is the largest 12-month underperformance since 2008,” Montanaro said.
“Financial history would suggest that as the political uncertainty starts to fade in the coming weeks, this underperformance will begin to turn: small-cap is an obvious beneficiary of an improving economic backdrop.”
He says earnings per share growth expectations for the companies within the fund have already stated to improve, from 9 per cent at the beginning of the to 18 per cent in March.
“The Q1 reporting season in April will be closely watched for signs that this trend is being realised.”