A valuation anomaly across the small cap space and a tough economic environment are likely to raise M&A activity in the sector, according to Fidelity’s Alex Wright (pictured).

The FE Alpha Manager says that economic uncertainty has led to a pull-back from investment in companies at the very lowest end of the capitalisation spectrum and this has created a significant opportunity for the Fidelity UK Smaller Companies fund.

"Smaller companies have generally outperformed during periods of stronger economic activity and underperformed in recessionary times," he explained.

"The interesting thing is that through the economic recovery since 2009 we haven’t seen this trend of outperformance and in fact they underperformed in periods last year."

"Small cap valuations today are therefore very favourable and this leaves the opportunity for M&A activity going forward. The mid cap market is trading at about a 16 per cent discount while there is a 37 per cent discount for small caps on a historical basis."

He added: "People are understandably worried about the economic outlook and have shied away from the very smallest companies. This is creating an opportunity in the companies where much of the fund is exposed."

The manager’s investment process centres on the very smallest firms as these have the potential for huge growth and are overlooked by the largest funds in the peer group.

"The companies which make up the Hoare Govett index have an average of 34 analysts researching them while the smallest companies in the £100m to £500m market cap range where this fund is focused only have an average of nine," he said. "There are more companies to choose from and fewer analysts researching them."

Wright begins by looking for companies that are unloved by the rest of the market but have some mechanism for downside protection.

"This comes in the form of tangible measures such as high levels of cash on balance sheets or more intangible protection such as long-term contracts, high barriers to entry and a strong product development line," he continued.

"I generally buy companies that have already underperformed and the management have recognised that there is need for improvement."

"I buy companies that are valued as ex-growth but I see the potential for change going forward. In the second stage there comes a change in perception and this is where I see real outperformance and in the final stage companies begin to reach the value targets I’ve set for them and I look to recycle money back into unloved ideas."

One of many examples where this process has proved to work is in the story of oil and gas explorer Cove Energy.

"I bought it in August 2011 after a series of discoveries in Mozambique," Wright explained. "The fact that they had found oil acted as downside protection and there was also net cash on the balance sheet. Cove Energy had a strategy to monetise their assets and our large cap analysts told me that the oil majors had taken an interest in the area."

"The majors came knocking much earlier than expected and this morning Shell put in a bid of 220p so this is one name which has made a lot of money for the fund."

With returns of 143 per cent, data from FE Analytics shows that Fidelity UK Smaller Companies is the best-performing fund in the sector over three years. By comparison FE Alpha Manager Harry Nimmo's £1bn Standard Life Inv UK Smaller Companies fund has returned 106 per cent during this period while the average fund in the sector has returned 84 per cent.

Performance of funds vs sector over 3-yrs



Source: FE Analytics

Wright finished: "M&A is set to be a significant theme over 2012. Balance sheets in large corporates are in good health and the tough economic environment as well as low levels of lending mean the opportunity for mid-sized firms to invest in their own business and grow organically is very low. This will inevitably lead to expansion via acquisitions."

"What’s nice about looking at unloved companies is that few investors are looking at them because they’ve underperformed in the past. This means you are basically getting something for nothing and there is space for share price appreciation."