It’s been a difficult time to be invested in UK smaller companies over the past year or so. 
Following the asset class’ stellar gains of more than 40 per cent in 2013, investors started taking profits from high-multiple growth stocks and moved into the perceived safety of defensive large-cap equities in the spring of last year due to wider macroeconomic risks.
Smaller companies then continued to struggle throughout 2014 as investors became increasingly ‘risk-off’ – with wider market volatility and redemptions from notable UK multi-cap funds weighing on sentiment.
Data from the Investment Association shows the IA UK Smaller Companies sector has been hit by net outflows in each of the last 11 months with some £1.1bn coming out of the peer group over that time.
It means UK small-caps funds have made just 0.12 per cent since their peak in March last year while the FTSE 100 has gained 8.46 per cent, according to FE Analytics.
Performance of sector versus indices since March 2014
Source: FE Analytics
While that performance and selling meant valuations improved, the large majority of industry experts were avoiding smaller companies due to the general election and the political uncertainty that came with it.
However, to the surprise of nearly all market participants who were expecting a hung parliament, the Conservatives managed to win an out-and-out majority when the UK went to the polls last Thursday.
The result meant that nearly all UK assets appreciated in value as the election uncertainty fell away, including the IA UK Smaller Companies sector which jumped 1.47 per cent on Friday.
Therefore, can investors expect the rally to continue given that the major risk which was dominating the asset class has now subsided? Simon Evan-Cook, fund manager at Premier, thinks so. He had become wary of small-caps last year but has been topping up his exposure.
“We are believers in small-cap investing, we think the greater inefficiencies give the best active managers opportunity to make highly attractive returns,” Evan-Cook (pictured) said.
“We also think investors generally overestimate the risks attached to a well-picked portfolio of smaller companies, while simultaneously underestimating the risk of holding large-caps. As such, we need a very good reason to avoid small-caps.”
“We had that at the start of last year when they became expensive compared to the rest of the market and were attracting too much hot money. As such we cut back significantly going into 2014.”
“However, that valuation premium has now gone, as has much of the flightier money. The decisive result from the general election is also a boon, so we are again topping up our small-cap weighting at the expense of large caps.”
The nimble £145m Franklin UK Smaller Companies fund is one of the portfolios Evan-Cook has been buying recently.
Under previous manager Stuart Sharp it had been one of the worst performers in the sector, but since Richard Bullas and FE Alpha Manager Paul Spencer took charge in June 2012 and rejigged the portfolio, it has bounced back considerably.
According to FE Analytics, it has been a top quartile performer over that time with returns of 84.06 per cent, beating its benchmark – the Numis Smaller Companies ex IT index – by close to 15 percentage points in the process.
Performance of fund versus sector and index since June 2012
Source: FE Analytics
It is a concentrated portfolio of just 44 holdings (the top 10 account for 33 per cent of total assets) and has an ongoing charges figure of 1.04 per cent.
Richard Scott, co-manager of the PFS Hawksmoor Vanbrugh and Distribution funds, agrees that now is a good time to buy UK smaller companies. As a result, Scott and his team have focused on the closed-ended sector due to attractive discounts that are now on offer.
“We do think small-caps offer very good value relative to the UK equity market in general,” Scott said.
“Three we like are Aberforth Smaller Companies, BlackRock Throgmorton and, for micro-cap, the River and Mercantile UK Micro Cap Investment Trust. Not only are the trusts on attractive ratings (the recently launched R&M trust apart), but the relative value of smaller companies and micro-caps are looking good to us.”
He added: “It is interesting to see that some of the multi-cap managers are increasing exposure to small-caps, such as Alex Savvides at JOHCM.”
FE Alpha Manager Savvides, who heads up the JOHCM UK Dynamic fund, recently told FE Trustnet that he was upping his exposure to small companies.
“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,” Savvides said at the recent FE UK Growth Event.
“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.”
There are other signs that sentiment was improving towards the sector as roughly two-thirds of the 45 investment professionals who attended the event said they had either increased or were thinking of increasing their allocation to small and mid-caps in light of the poor period of performance since February last year.
Source: FE Trustnet
However, this increased appetite for risk hasn’t translated into more expensive valuations.
Apart from the recently launched R&M UK Micro Cap and Miton Microcap trusts, which have jumped onto premiums, the average portfolio in the IT UK Smaller Companies sector is currently on a 14.4 per cent discount to NAV, according to the AIC.
On top of that, 10 out of the 13 trusts which have a long enough track record are now trading on wider discounts than their three-year averages.
Source: The AIC
However, while Evan-Cook says there is good value on offer, he urges investors to not become too carried away.
“However, I wouldn’t say we are ‘filling our boots’, as the valuation discount is not extreme and we are possibly at a stage of the cycle that will not favour small caps,” Evan-Cook said. 
“Additionally, while the decisive election result has removed one source of uncertainty, the likelihood of a referendum on Europe introduces another.”
Rob Morgan, pensions and investment analyst at Charles Stanley Direct, agrees that the election result has thrown up more risks for investors to worry about – such as the ‘in-out’ referendum and the rise of nationalism in Scotland.
Because of that, he says investors either need to very selective in the UK smaller companies sector or avoid the asset class altogether.
“I would expect something of a relief rally for certain stocks sectors. We have already seen some estate agents and bookmakers do well as a result of the risks of a mansion tax and greater gambling regulation dissipating,” Morgan (pictured) said.
“I think it’s largely going to be a stock by stock phenomenon –hence a focus on the stockpickers and managers that have ability to add alpha.”
“However, the Conservative victory also presents the new uncertainty of a referendum on EU membership, which I believe would have a larger impact on many smaller businesses than the outcome of the general election.”
He added: “So I would actually be somewhat cautious with this now hanging over us.”
