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Why now is the time to buy small-cap funds

07 September 2016

Gervais Williams, fund manager at Miton, outlines the investment case for upping your portfolios exposure to small caps.

By Jonathan Jones,

Reporter, FE Trustnet

Small caps look set to outperform for many years as investors and fund managers will have to get used to a low growth world, according to Gervais Williams, managing director and fund manager at Miton.

While the consensual view is that smaller companies offer higher potential returns, FE data shows that hasn’t really been the case over the longer term.

According to FE Analytics, while the FTSE Small Cap index has outperformed the FTSE 100, it has only done so by 7 percentage points and has been far more volatile and posted a significantly larger maximum drawdown – the most an investor would have lost if buying and selling at the worst possible times – over 10 years.  

The picture was even worse during the 1990s, when the small-cap index underperformed the FTSE 100 by a hefty 150 percentage points over a 10 year period.

Performance of indices during the 1990s

 

Source: FE Analytics

Williams says this extended period of meagre performance from small-caps relative to large-caps stems from economic trends such as the move towards globalisation, which has clearly benefitted multinational corporations.

In turn, Williams says fund managers had become used to holding larger companies and profiting from the strong economic growth witnessed prior to the global financial crisis. However, with economic growth still anaemic due to various drivers and that trend set to continue, the manager expects smaller companies to display the type of strong returns relative to large-caps last seen during the 1960s and 1970s.

“It’s kind of neater and tidier to have portfolios with a few big companies rather than have lots of little ones so we’ve got a whole generation of fund managers who have got used to investing in big companies and they’ve learnt to live without small companies which is fine because they’ve made heaps of money and the index has gone up,” Williams (pictured) said.

“[However] growth has slowed and it’s a case of get used to it,” he added. “World growth is stagnating and while there will be some growth – it won’t be completely zero – big companies will struggle because when you’re big you don’t grow much faster than the world.”

He points to the EU referendum as a sign that people are looking to break away from globalisation, with large internationally-facing companies more impacted by this shift than smaller, domestically-focused companies.

The reasons for owning small caps are bountiful, according to Williams, who points to faster growing dividends at the lower end of the market, low valuations and the fact that these companies typically offer a hedge to economic trends.

“Not only are they growing better, not only are they getting cash paybacks, but the dividend growth is now coming through better than the main market” he said.


“There has been a slight interruption to service in the last 10 weeks with Brexit as suddenly the devaluation of sterling by 15 per cent means that international dividends like shell and HSBC have gone up on a one-off basis but it hasn’t changed the trend.”

Performance of indices since Brexit vote

 

Source: FE Analytics

“The trend is that the organic growth of dividends at the smaller end is better than the main market.”

As well as this, small caps remain cheap, with Williams noting that while the largest UK listed stocks are trading P/E ratios of 18 times or more, the smallest stocks in the index are on multiples as low as 8 times.

“Some of these small caps at the bottom end of the market are disgustingly cheap – valuations are still very low,” he said.

“Not only have we got companies that are more vibrant, bucking the economic trend and growing their dividends better but we also have companies which are already sub-normally valued and we expect these to move back to the norm.”

However, many will remain concerned that smaller companies are more likely to go into liquidation than blue-chips making the risks much higher.

“Inefficiencies are more common [at the lower end of the market]. You can find companies that are just at the wrong price and you can find companies that shoot up to way-too expensive,” Williams conceded.

“Small companies – some of them will get stuffed – it’s not easy – but some will do really well,” he said.


By using a fund however, this risk can be somewhat mitigated and Williams’ CF Miton UK Smaller Companies has been one of the best performing in the sector since launch.

Performance vs sector and FTSE Small Cap (ex IT) since launch

 

Source: FE Analytics

The fund, which he runs with FE Alpha Manager Martin Turner, has returned 92.78 per cent to investors since its launch at the end of 2012, 19.15 percentage points ahead of the FTSE Small Cap and 30.58 percentage points ahead of the sector average (IA UK Smaller Companies).

It has been in the top quartile among its peers since launch, though the five crown-rated £155m fund has been one of the more volatile over the period.

Williams admits that investors will never have a portfolio full of small caps, but says investors are beginning to up their exposure.

“They’re never going to put 100 per cent of their portfolios in small caps it might only be 10 or 15 (per cent) but it’s coming up from a micro percentage now.”

He says this trend will also be prevalent within funds, with many managers moving further down the market to outperform the FTSE 100-dominated FTSE All Share.

“Almost all small cap managers you meet will all be loaded up with mid-caps because that’s where all the gains have been had so mid cap players will start putting money into small/micro because it’s outperforming,” he said.

“What we’re going to find is the very smallest companies outperform – so we’ll see cash moving down. Ultimately we think that people will learn to love small companies,” Williams said.

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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.