Investors have turned their backs on UK smaller companies for some time now, but Unicorn’s Simon Moon and Fraser Mackersie argue that there are number of reasons why this part of the market looks increasingly attractive.
As the graph below shows, the Numis Smaller Companies ex Investment Trusts index was down 1.85 per cent over the course of 2014 while the FTSE 100 managed a 0.74 per cent gain. From the Numis’ peak on 6 March 2013 to its trough on 16 October, the index lost 15.29 per cent.
Performance of indices over 2014
Source: FE Analytics
Meanwhile, the IA UK Smaller Companies sector has been hit with net retail outflows for 11 straight months, with the Investment Association’s most recent figures showing £161m was pulled from the sector during March.
However, Moon and Mackersie believe that the difficult past year has left UK smaller companies looking attractive relative to their larger peers. The managers run the Unicorn UK Income fund, which resides in the IA UK Equity Income sector but has the bulk of its assets in small-caps.
The managers, who have headed the five FE Crown-rated fund for around one year following the death of former manager John McClure, argue there are a number of reasons why investors should be considering small-cap income and point out that the most obvious is valuations.
Small-cap valuations
Moon said: “Now you have a relative valuation gap between FTSE 100 stocks and small-cap stocks to the extent that you haven’t seen the likes of since the 2011 sovereign debt crisis and, prior to that, the 2008/9 financial crisis. Both of those periods represented a fantastic opportunity for small companies.”
As the following graph shows, smaller companies are currently trading at about 80 per cent the 12-month forward price/earnings ratio of their larger rivals. While the gap was bigger during the financial crisis, the current difference is still much wider than usual.
Relative value in small-caps
Source: Unicorn Asset Management/Peel Hunt
FE Analytics shows small-caps have bounced back strongly after difficult periods such as 2008 and 2011.
In 2009 and 2010, the Numis Smaller Companies ex Investment Trusts index was up 60.73 per cent and 28.49 per cent respectively, while the FTSE 100 gained 27.33 per cent and 12.62 per cent; in 2012 and 2013, the Numis index’s respective gains were 29.94 per cent and 36.93 per cent while the FTSE 100 was up 9.97 per cent and 18.66 per cent.
Moon added: “Companies in the FTSE 100 tend to be in a very low-growth environment with a decent utility-like revenue stream coming through. Frankly, that’s not particularly exciting and on a relative valuation small-caps offer better value and growth you’re unlikely to find in the FTSE 100.”
Diversifying income
Another reason for looking at small-caps now, they argue, is to diversify away from the mainstream UK equity income holdings that dominate most funds in the sector.
Mackersie said: “It’s just about diversifying your income. A lot of funds are bunched into the same few names, but you expect that when so few companies pay most of the dividends. But we try to do something that’s a little bit different.”
According to the Capita UK Dividend Monitor, 90 per cent of all UK dividends come from companies in the FTSE 100. Meanwhile, around half of all dividends come from just five firms: Royal Dutch Shell, AstraZeneca, BP, Vodafone and GlaxoSmithKline.
FE Analytics shows that 42 of the 88 funds in the IA UK Equity Income sector has Shell as top 10 holding, 45 have AstraZeneca, 41 have BP, 29 have Vodafone and 53 have GlaxoSmithKline.
Moon points out that several FTSE 100 income stalwarts have already cut their dividends this year, including Centrica and Tesco, while question marks hang over the pay-outs of other big names.
“There’s a bit of risk there but if you have a few more dividend cuts in the FTSE 100, it will focus people on yield opportunities further down the market cap scale,” he added.
Safety of dividend cover
The managers also argue that small-caps are attractive for income investors because of the relatively high levels of dividend cover found in this part of the market.
According to Unicorn, the FTSE 100 as a whole is 1.6 times covered, but this figure tends to get smaller the higher up you move. Of the top five payers, AstraZeneca has the highest dividend cover at 1.5 times, while GlaxoSmithKline’s is 1.1 times covered, Shell’s is one times, BP’s is 0.9 times and Vodafone’s is just 0.5 times.
Moon says that much higher levels of dividend cover can be found lower down the cap spectrum, noting that Unicorn UK Income is two times covered.
He said: “The dividend cover of the top five payers in the UK isn’t particularly generous and you don’t have growing earnings there.”
Moon and Mackersie have been named managers on the Unicorn UK Income fund since 1 January 2014 and took control of the portfolio after McClure passed away in June 2014. However, they had worked with the star manager for six years previously and have described themselves as being “fully indoctrinated” into his process.
Over their time on the fund, it has returned a bottom-quartile 3.78 per cent, compared with a 10.13 per cent average gain in the IA UK Equity Income sector and 6.77 per cent rise in the FSTE All Share.
Performance of fund vs sector and benchmark over managers’ tenure
Source: FE Analytics
However, this period coincided with the small-cap sell-off – which the managers had to deal with while suffering the inevitable outflows that followed the death of McClure. Fund pickers have broadly agreed to the two managers have a good chance of replicating McClure’s successes.
Over more recent time frames, the fund has returned to the top quartile of its sector and outperformed its FTSE All Share benchmark with a three-month return of 5.41 per cent and a six-month return of 12.59 per cent.
Unicorn UK Income has a clean ongoing charges figure of 0.81 per cent and yields 4.01 per cent.
