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Dan Nickols: Why your UK small cap fund won’t come roaring back next year

16 December 2014

Funds within the IMA UK Smaller Companies sector have largely struggled this year and FE Alpha Manager Daniel Nickols expects 2015 to be another tricky period for his asset class.

By Alex Paget,

Senior reporter, FE Trustnet

Investors should expect 2015 to be another tricky year for UK smaller companies funds, according to Old Mutual Global Investors’ Daniel Nickols, who warns that consensual levels of earnings growth will once again prove too high.

Smaller companies funds had been some of the major beneficiaries of the rally spanning 2012 and 2013, as a recovering economy and a greater appetite for risk among investors meant the IMA UK Smaller Companies sector returned close to 70 per cent over the period, compared to a 35 per cent gain from the FTSE All Share.

Performance of sector vs index between Jan 2012 and Dec 2013

   
Source: FE Analytics

On top of that, certain funds, such as R&M UK Equity Smaller Companies and Unicorn UK Smaller Companies, delivered barnstorming returns of close to 60 per cent in 2013 alone.

However, while some suggested that investors could expect more of the same in 2014, data from FE Analytics shows 77 per cent funds from the 53-strong sector have lost money year-to-date and FE Alpha Manager Nickols – who runs the Old Mutual UK Smaller Companies and UK Smaller Companies Focus funds – doesn’t think they will bounce back strongly over the coming 12 months.

“2015 will, I think, be another tricky year for the UK market, but I do expect it to be an environment where positive total returns can be delivered,” Nickols (pictured) said.

“UK GDP growth should be solid – at around 3 per cent – and I think the US will continue to grow well. At a global level, growth will be unspectacular and I expect that consensual levels of earnings growth of around 8 per cent for the UK market will – once again – prove too high.”

“This suggests that, even though we should still expect to see reasonable profit growth across the UK market as we look into 2015, a process of downgrading of forecasts will be seen over the coming months.”

Nickols says there have been a number of reasons as to why small-caps have struggled this year, with slower-than-expected international growth, weakness in the eurozone and sterling strength sparking earnings downgrades across the UK and prompting investors to lock in their stellar gains.

Whatever the reason, the average fund in the IMA UK Smaller Companies sector has lost 4.31 per cent this year. Interestingly, however, the sector has slightly outperformed the wider UK market over that time.


Performance of sector and index in 2014



Source: FE Analytics

Those figures are slightly skewed, though, as a result of Judith MacKenzie's five crown-rated PFS Downing Active Management fund’s return of more than 20 per cent. The next best performing portfolio in the sector – AXA Framlington UK Smaller Companies – has returned just 3.71 per cent.

Funds such as Schroder UK Dynamic Smaller Companies, M&G Smaller Companies and Standard Life UK Smaller Companies have all lost more than 10 per cent this year. Nickols’ two funds sit in the second quartile so far this year, but have both lost roughly 4 per cent.

Though Nickols is cautious on his asset class, he says there are a number of reasons to not to give up on smaller companies.

“There are plenty of reasons to be positive though,” Nickols continued.  

“Most obviously, the fact that starting valuations, as we enter 2015 are not high - the FTSE All Share index currently trades on a forward multiple of 13.3 times, while the Numis Smaller Companies index trades at a small discount to this at 13.1 times.”

“This compares to a 20-year average for the UK market of around 13.5 times earnings.”

The manager also says the re-opening of the initial public offering market (IPO) market over this year is another reason for optimism.

“We have long argued that, over time, the diversity of UK smaller companies indices has of itself been a key reason to invest in the asset class. Mispricing is more likely to occur when an opportunity set grows,” he explained.

“After a dearth of issuance for much of the post credit crunch period, no fewer than 76 companies came to the UK market in the first half of 2014, more than in the whole of 2013. Generally, the IPO market has attracted negative comment for much of that period, but in my view it is pricing and not quality per se that has been the issue.”

Nickols has bought into nine IPOs this year, including SSP, Just Eat, boohoo.com and Fever-Tree.

The manager took over his £820m Old Mutual UK Smaller Companies fund in February 2004 and his £125m Irish-domiciled UK Smaller Companies Focus fund – which is a more concentrated version – in January 2009.

According to FE Analytics, his larger fund has been the sector’s fifth best performing portfolio over 10 years with returns of 266.22 per cent, beating its benchmark – the Numis Smaller Companies ex IT index – by 80 percentage points in the process.


Performance of fund vs sector and index over 10yrs



Source: FE Analytics

The performance of his two funds has been more muted over five years, though they both sit in the second quartile and have beaten the index over that time.

Nickols’ two portfolios are a combination of structural growth names and special situations along with cheaply rated domestic cyclicals – such as construction, housebuilding and support services stocks. For example, industrials are his largest sector weighting in his UK Smaller Companies fund, accounting for 35 per cent of his assets.

There are a number of areas he is avoiding, however.

“We continue to believe oil and gas and mining will suffer from weak underlying commodity prices,” he said.  
“Food producers, where supermarket price wars continue to weigh, capital goods, where ratings look up with events, and the non-life insurance sector, where the rating environment remains in decline will, we think, underperform.”

Old Mutual UK Smaller Companies has an ongoing charges figure (OCF) of 1.05 per cent, while Nickols’ UK Smaller Companies Focus fund is slightly cheaper with an OCF of 0.93 per cent.
 

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Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.