Next year will be tough for UK small- and mid-caps but, through careful fund selection, investors will still be able to take advantage of attractive valuations, according to a selection of industry professionals.
For the four years until the end of 2015, stocks that were further down the cap spectrum were favoured among investors for their long-term growth prospects, with both the FTSE Small Cap and FTSE 250 indices comfortably outperforming the blue-chip index over this time.
Year-to-date, however, there has been a reversal of fortunes, with growth of the FTSE 100 index more than tripling efforts by the FTSE 250.
Performance of indices in 2016
Source: FE Analytics
Strong outperformance of the blue-chip index have been driven by concerns over Brexit. In the run-up to the EU referendum, investors favoured global-facing larger stocks as opposed to those that were more exposed to the domestic economy.
The performance gap between small- and large-caps continued to widen after the shock ‘leave’ result was announced and sterling plummeted; investors looked to exploit currency gains from global exporters rather than buy into UK domestics with uncertain futures.
With Article 50 expected to be triggered during the first quarter of 2017, UK equities investors aren’t out of the woods yet. But, with valuations across small and mid-cap companies at historically cheap levels, should 2017 be the year for investors to dip their toes back into the water? 
Ryan Hughes (pictured), head of fund selection at AJ Bell, says the outlook for small- and mid-cap is challenged but argues that this will be a common theme for all UK equities next year, given that Brexit issues will create a natural headwind for people wanting to allocate to the county.
“Because of that uncertainty, I think it’s easy to make the case that domestic earners – particularly in the mid and small-cap space – are entering a challenging environment,” he said.
“You might not necessarily want to buy the market but, if you can find managers that are really focusing on the winners – and there will always be winners and losers in any market environment – if you can find those active managers then I think you still have an opportunity to make a good amount of money.”
AJ Bell is currently gaining exposure to the market area through its holding in Neil Woodford’s Patient Capital Trust which, despite investing across the cap spectrum, holds a significant portion of smaller companies.
“I also think quite an interesting way of playing mid-caps next year is through a long/short strategy,” Hughes continued. “Old Mutual are probably the best mid-cap team in the market and they recently launched a long/short mid-cap fund which we are monitoring.”
“I think that could be a really interesting way to play mid-caps next year because of the dispersion of returns between the winners and the losers. So you can allocate to mid-cap and allocate to a good manager with strong stock-picking capabilities who also has the flexibility not to be 100 per cent exposed to some of the losers in that environment.”
Launched in April this year by Tim Service, Old Mutual UK Specialist Equity is £321m in size and currently holds 107 positions, 49 of which are short.
The team adopts both a top-down and bottom-up process in terms of stock selection and, since its launch, it has returned 8.25 per cent. While it is benchmarked against the EBF Eonia Average index, it has comfortably outperformed both the FTSE Small Cap and FTSE 250 indices over this time frame.
Performance of fund vs sector, benchmark and indices since launch
Source: FE Analytics
Patrick Connolly, head of communications at Chase de Vere, says investing in smaller companies is more suitable for higher risk growth investors who want the potential of better returns and are willing to accept greater levels of volatility and potential short-term losses along the way.
While mid- and small-caps tend to fall harder and faster during times of difficulty, he says smaller companies – which are often dynamic firms – should be expected to outperform their larger peers over the long term.
“Investors are likely to have some exposure to small companies through more broad-based equity funds that they hold. It is important for them to understand this and for many there won’t be the need to specifically hold additional smaller company funds as well,” he said.
While the UK’s decision to leave the EU could indeed be detrimental to smaller companies – particularly those that import goods and could be bruised by a depreciating sterling – Connolly says investors shouldn’t give up on the space.
“Good quality smaller company fund managers have the potential to uncover fantastic companies with great growth prospects, which have been overlooked by other managers. This isn’t usually the case with managers investing in larger companies as information about these companies is more widely known,” he added.
“Funds we recommend include Liontrust UK Smaller Companies and Old Mutual UK Smaller Companies.”
Performance of funds vs sector and benchmarks over 5yrs
Source: FE Analytics
Jason Hollands, managing director at Tilney Bestinvest, believes a good way to navigate next year’s challenging conditions while holding small- and mid-caps is to buy into multi-cap funds that historically overweight the market area, such as Liontrust Special Situations. For those looking to narrowly focus on these areas of the market though, he says Henderson Smaller Companies Investment Trust and AXA Framlington UK Mid Cap are good options.
“While I don’t disagree with the fact that large-caps overall have the advantage for now, small-cap funds could be a bit of a wildcard in 2017 as the rotation into large caps may have substantially played out as large-caps have become a consensus trade and there are certainly some relative valuation advantages,” he said.
Despite predicated negativity when it comes to UK growth, Hollands says economic data has proven far more resilient given there is now an accommodative credit environment and increased fiscal measures to support the UK.
“While there are plenty of UK domestic business lurking further down the market cap spectrum, there also many businesses that have UK cost bases but high overseas earnings which have the potentially to benefit significantly from the competitive advantage provided by weaker sterling, such as Fevertree Drinks (tonic waters and mixers), AbCam (protein testing kits for life scientists or Ultraelectronics (defence technology) as well as businesses with models that are not overly sensitive to the economic environment such as EMIS, a provider of data software to NHS authorities,” he explained.
Ben Willis, head of research at Whitechurch Securities, says the tailwinds that have driven UK mega-caps in 2016 – such as the weak pound and a recovery in oil prices – may not drive indices higher in 2017.
Not only this, he believes undervalued cyclical stocks could re-rate from here if we see a resilient UK economy, stability in the pound and sticky inflation.
“We certainly believe that stock-picking in medium and smaller companies that have been out of favour could prove rewarding next year, and we will retain our preference for a contrarian value focused approach here,” he said.
“But this does come with a caveat: we remain in an environment that will continue to be dominated by short-term political news-flow.”
“Rather than trying to make big calls on unpredictable factors, our focus is to take a ‘barbell approach’ and maintain our current diversified equity exposure across the UK market cap spectrum.”
Neil Jones, investment manager at Hargreave Hale, says small- and mid-caps tend to be more exposed to the fortunes of the UK economy and, in this respect, he is reasonably optimistic.
“Whilst we will see the commencement of Brexit negotiations and this may hold back some capital expenditure, the currency should start being beneficial in the first half of the year and be positive for general economic conditions,” he said.
“In addition, the weakness of sterling could easily see UK companies become takeover targets, with smaller companies vulnerable to larger overseas predators. If we start seeing more signs of this, I could see investors allocating more exposure to the sector.”