Decent earnings growth along with an improved economic and business backdrop means smaller companies will continue to outperform the wider market, according to FE Alpha Manager Daniel Nickols. 
Sentiment towards smaller companies had been depressed during the early stages of 2015 thanks to considerable falls during the previous year, the uncertainty surrounding the general election and sustained outflows from the IA Smaller Companies sector.
Data from the Investment Association shows that the peer group was hit by 12 consecutive months of redemptions which, in total, meant £1.2bn was pulled out of the sector between May 2014 and May 2015.
All told, this led to the underperformance of small-caps relative to the wider UK equity market as the graph below shows (which highlights the performance of indices between small-caps’ peak in March 2014 up to the UK general election in May).
Performance of indices between March 2014 and May 2015
Source: FE Analytics
However, since the unexpected Conservative majority at the polls and numerous macroeconomic headwinds that have faced the FTSE 100, smaller companies have come rallying back strongly.
Nickols, manager of the £850m Old Mutual UK Smaller Companies fund, says that there is no reason why the rally won’t continue.
“Are you small-caps too expensive? No, I don’t think they are in the current environment. Has earnings growth waned? No, I don’t think it has,” Nickols (pictured) said.
“Yes, it’s true that both the FTSE All Share and UK smaller companies stand at somewhat of a premium to their historical average.”
Since the general election, the Numis Smaller Companies ex IT and the FTSE Small Cap index (which are far more domestically orientated than the FTSE 100) have delivered gains of more than 3 per cent.
The more internationally focused FTSE 100 index, thanks to the falling oil price, banking fines, concerns over China’s economy, the potential for a rate rise and Greek debt negotiations, has fallen 3.41 per cent over that time.
Performance of indices since the UK general election
Source: FE Analytics
This recent performance from small-caps, along with their stellar gains in 2012 and 2013, has left the Numis index trading on a forward P/E ratio of 15.3 times, compared to its historical average of 13.5 times.
Nevertheless, Nickols isn’t concerned.
“To what extent is that justified? I think on a relative basis this reflects the paucity of other alternatives elsewhere. When you look at the returns available on bonds or cash it is a very difficult environment so it’s not surprising to my mind that our world trades at something of a premium to history.”
“That said, UK smaller companies are trading at a discount to the wider market. Not only are they trading at a discount, I think the growth outlook is at least as good as the wider market. We still think the total return available within this environment should be attractive.”
The major reason for that, according to Nickols, is because the economic backdrop is becoming increasingly positive.
While he admits that economic growth will remain subdued from a top down point of view, he says the fact that consumers now have more money spend gives businesses more confidence.
“I’m not going to sit here and argue that we are to see anything better than trend like growth and the UK clearly remains somewhat of an unbalanced economy. The fact is, our economy remains very biased towards consumption,” he said.
“That said, if we look at some of the moving parts within that, the combination of wage growth finally coming through and some of the non-discretionary elements of household spending (food and fuel coming down in price) – the simple fact is the amount of cash available for spending on the part of UK households is clearly rising.”
Performance of index over 1yr
Source: FE Analytics
“This is a benign environment and should provide a very positive backdrop for UK smaller companies particularly as our index, by its very nature, is very biased towards the UK economy.”
This is certainly a change in stance from Nickols, who came into the year with a relatively bearish view on his own asset class.
In his outlook for 2015, he warned that small-cap investors could be in for another tricky year as consensus around earnings growth was likely to be overestimated.
“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 told FE Trustnet in December.
So what is behind this change in stance? Nickols says the main reason he is bullish on the small-caps once again is because of the current political environment.
“In a world of reasonable growth, but a world nonetheless beset with a range of uncertainties, I regard the UK as a beacon of relative certainty,” he explained.
“I think the recent election was a pivotal moment. Clearly, leading up to that there was a lot of uncertainty around and a lot of sitting on hands taking place the clarity of the result makes a significant difference to the prospects for the UK going forward.”
“Not just for five years but arguably (delving into politics for a second) even as a long as 10 years of a business friendly government. I think people underestimate how important that is.”
“We spend a lot of our time meeting with company management teams and I’ve already lost count of the number of board members, chief executives who have volunteered the outcome that it was a significant outcome for them and gives them confidence.”
Nickols isn’t alone in his views on smaller companies with many multi-cap managers upping their exposure to the asset class for similar reasons, such as Standard Life’s Thomas Moore and JOHCM’s Alex Savvides.
Ben Willis, head of research at Whitechurch, has also been increasing his clients’ allocation to small-caps.
“These areas of the market tend to be domestically focused and economic data released over the month was generally positive,” Willis said.
“Q1 GDP growth figures were marginally revised upwards, construction industry figures were strong and consumer confidence reached its highest level since early 2000, with more consumers than ever now saying it was a good time to make major purchases.”
Nickols has managed the Old Mutual UK Smaller Companies fund since January 2004.
According to FE Analytics, it has been the fourth best performer in the sector over that time with returns of 442.43 per cent, meaning it has beaten the Numis Smaller Companies ex IT index by close to 150 percentage points.
Performance of fund versus sector and index under Nickols
Source: FE Analytics
It is outperforming both the sector and index over one, three, five and 10 years as well. Old Mutual UK Smaller Companies has also beaten its benchmark in eight out of the last 10 calendar years. The fund is highly-rated within the industry, as a result of its strong performance and Nickols’ proven stock-picking ability.
For example, it features on Square Mile’s ‘Academy of funds’ as the team rate the consistent nature of its process.
This is a good experienced team investing in an area of the market where talented stock pickers can uncover good opportunities. This is a wellresourced and able group of likeminded investors that clearly work well together,” Square Mile said.
“The stock selection process does have a growth bias in it but the team's top down view guides them towards more cyclical or defensive companies at appropriate junctures. Such pragmatism has been adopted to ensure that the fund performance is more consistent.”
Old Mutual UK Smaller Companies has a clean ongoing charges figure (OCF) of 1.03 per cent.
