Smaller companies should continue to outperform their large-cap rivals, according to Franklin Templeton’s Richard Bullas, who says they should benefit from an improving economic backdrop, attractive valuations, an exciting initial public offering (IPO) pipeline and the fact it is an under researched area of the market. 
While macroeconomic headwinds such as China’s slowdown, falling commodity prices and uncertainty surrounding future interest rates have rocked the blue-chip indices like the FTSE 100, mid and small-caps have performed strongly so far this year.
According to FE Analytics, the FTSE Small Cap index has returned 7.63 per cent year to date. While the index has narrowly underperformed the FTSE 250, it is comfortably ahead of the FTSE 100 which is down 0.68 per cent in 2015.
Performance of indices in 2015
Source: FE Analytics
Not only have they outperformed large-caps, but smaller companies have been half as volatile and had a maximum drawdown – which measures the most an investor would have lost if they had bought and sold at the worst possible times – which is 2.6 times lower than the FTSE 100 this year.
The major reasons for that difference in performance is due to the fact that large-caps tend to be more internationally facing, while mid and small-caps are usually more biased towards the domestic economy.
Given the UK economy seems to be on an upward trajectory while headwinds in the form of China and low commodity prices continue to dog some of the FTSE 100’s biggest constituents, Bullas – manager of the Franklin UK Smaller Companies fund – expects his area of the market to continue to outperform well into 2016.
“Looking at the current UK small-cap landscape, we are cautiously optimistic. We think the fundamental backdrop and support for UK small caps is largely positive at the moment, and we feel that is likely to continue in 2016,” Bullas (pictured) said.
“We’re also broadly positive about the UK economy. We have a fairly healthy labour market and fairly low inflation. Real wages are on the rise, with low food inflation and low petrol prices for consumers, meaning more cash in their pockets and rising discretionary spend.”
“Meanwhile, we continue to be in a low interest-rate environment, and we think the current heightened global uncertainty is likely to have deferred any immediate threat of a UK rate increase.”
“Even though we’re not in a superior growth period, gross domestic product growth in the United Kingdom of 2 per cent–2.5 per cent over the next two to three years seems to us to be achievable. While not stellar growth, it is steady growth, and we think it should supply support and confidence for companies to invest and grow.”
There is no denying that mid and small-caps have been a very profitable area for investors over the medium term, as bombed out valuations after the financial crisis, an improving economic outlook and restored investor confidence has pushed the asset class higher.
In fact, FE data shows that since markets bottomed after the crash in March 2009, five of the top 10 performing funds in the Investment Association universe sit in the IA UK Smaller Companies sector; namely Fidelity UK Smaller Companies, Schroder UK Dynamic UK Smaller Companies, R&M UK Equity Smaller Companies, Investec UK Smaller Companies and AXA Framlington UK Smaller Companies.
Source: FE Analytics
Nevertheless, Bullas says that valuations are still attractive within the UK small-cap space despite that performance.
“Meanwhile, small-cap valuations look to us to be attractive relative to the rest of the market, which is always a good starting point. Given the domestic bias to the earnings of smaller caps compared with larger caps, to us small caps seem to be more attractive as the global growth outlook faces numerous headwinds,” Bullas said.
“Furthermore, there may be greater scope for better earnings to come through. I expect to see greater progression on profit growth for small caps vis-a-vis the rest of the market, which could lend support to small caps as an asset class and a narrowing of the valuation discount.”
“There also seems to be a healthy merger and acquisition environment and equity markets appear willing to support deals. Many companies across the size spectrum are looking for growth—particularly acquisitive growth—to supplement muted organic growth.”
He added: “Small caps can offer rich pickings for larger companies. We think this environment is generally supportive of valuations.”
Bullas is mindful of the fact that there are risks facing UK smaller companies, though, namely in the form of uncertainty around interest rates. However, he is confident any hike is likely to be small and unlikely to derail consumer confidence.
The manager has run the £184m Franklin UK Smaller Companies fund with FE Alpha Manager Paul Spencer since June 2012.
According to FE Analytics, it has been a top quartile performer in the sector over that time with returns of 96.41 per cent, meaning it has beaten its benchmark – the Numis Smaller Companies ex IT index – by close to 25 percentage points in the process.
Performance of fund versus sector and index under Bullas and Spencer
Source: FE Analytics
It has also outperformed the sector and index in each calendar year since they have been in charge and is currently sitting in the top decile in 2015 with gains of 18.62 per cent.
Of course, investors may not be too surprised to hear a UK smaller companies manager saying small-caps should perform well, but many other market commentators are confident on the asset class’s prospects.
Mark Dampier, head of research at Hargreaves Lansdown, told FE Trustnet in an article this morning that it was an area of the market hat all investors should have exposure to.
“You have to be patient and my view is that most people are just patient. I just think mid and small-caps will always be a good area to be invested in over the longer term. I think it is the main area to invest in on the whole,” Dampier said.
However, Bullas says investors shouldn’t look at the asset class as a homogenous group as he is focusing one part of the index in particular.
“In the United Kingdom, some small-cap benchmarks have a remit to invest in companies way up in the mid-cap-focused FTSE 250. Some ostensibly small-cap portfolios can include very large mid-caps with market capitalisations of £2 billion to £3 billion and above.”
“Whilst there are some multi-cap players and bigger funds looking for mid- to small-cap exposure, we find they tend to focus on the bigger names in the space. The very small end tends to get overlooked because it is a specialist area with fewer market participants operating there.”
“In our view, as you move down the market-cap spectrum, the market becomes more inefficient. Mispricing and misperceptions can create opportunity, and we try to find underappreciated businesses which we believe offer the opportunity for a potential rerating as they grow larger and become a target for the wider investment community.”
