Small-caps have been on an incredibly strong run in recent years, following a period of disappointment following the financial crisis in 2008.
Indeed, over the last five years the FTSE Small Cap (ex IT) has returned 115.62 per cent, more than double the FTSE 100.
Performance of indices over 5yrs
Source: FE Analytics
This strong run of performance came despite a disappointing 2016, where smaller companies returned 12.54 per cent compared with 19.07 per cent gain for the large-cap index.
Dan Harlow, manager of the £288m, four crown-rated AXA Framlington UK Smaller Cos fund, says smaller companies have seen an uptick in investor sentiment in recent years.
He said: “Small caps have benefitted ultimately from an improving economic environment and sentiment towards them has improved as a result of that.
“They have a bias towards being more domestically-focused so statistically they have that greater gearing to an improving environment.
“While I don’t think economic growth over the last five years in this country has been stellar there has been growth and I think that environment has been a reasonable one for young companies to prove out their models. 
“The great thing about young companies is that the best ones aren’t dependant on GDP for their growth they are very much there to grow their markets, to take share. They are younger, they are more dynamic and more innovative so they are able to capitalise on that.
“You have had an asset class that had suffered around the downturn of the financial crisis and has bounced back and you’ve had some real successes that have come out of that.”
Last year’s EU referendum had a significant impact on smaller companies as UK investors sought refuge in more internationally-focused, large cap stocks.
Uncertainty around progress of Brexit negotiations and the type of deal UK authorities might strike with the EU could continue to impact markets in 2017, says Harlow.
“I think last year we clearly saw a weariness towards the state of the UK economy and everything associated to a potential Brexit slowdown,” he said.
“The general view was that it would be a bad thing for an environment where more domestic companies would operate.
“On the other side of the fence your international businesses, your dollar earners, have benefited and in the middle of the year there was a flight to safety and a general move towards names that had less gearing to an economy that was deemed to be susceptible.
“The good news about last year was that small caps delivered some decent absolute returns, it just happened to be that the big caps outperformed.”
The referendum result also saw a fall in sterling as concerns over the impact on the UK economy were raised.
Indeed, sterling has fallen 11.82 per cent over the last year against the US dollar over the last year and is 15.42 per cent lower from the day of the EU referendum.
Since the drop-off in sterling, some smaller companies have come under pressure, Harlow notes: “There are speed bumps around, we have to be very wary around inflation and clearly part of that is linked to the depreciation in sterling since the referendum last year and that’s causing some challenges for businesses that are importing raw materials and paying more for those.”
Performance of sterling vs dollar over 1yr
Source: FE Analytics
However, the fall in sterling also creates opportunities for those further down the cap spectrum, particularly when it comes to M&A activity.
At the end of last year, three smaller companies, Lavendon, Brammer and e2v Technologies were all approached for takeovers and while Harlow’s fund did not own any, two of his companies have been bought in 2017 already.
“What we’ve definitely seen is the likelihood of M&A picking up particularly with depreciating sterling assets – if you are an overseas buyer suddenly coming here things are 15 per cent cheaper,” the manager said.
“We didn’t own them but the likes of Lavenden, Brammer, e2v all got taken over in the last quarter of last year and two of those were by international trade buyers.
“We will see more. The fund had two takeovers in the first couple of months of this year – neither at huge premiums unfortunately – but Ithaca Energy has done very well and Delek an Israeli group has made an approach and then Booker was taken over by Tesco.”
He added: “I still think given a reasonable benign environment, albeit one with some risks out there we are still likely to see further M&A activity in small-cap land.
“We would reckon on losing one-to-two a year to M&A as an average over time. We’ve already had two this year and I wouldn’t be surprised if we had one or two more over the next nine months.”
Yet, this can cause its own problems for small cap investors, as losing the best investments means they have to find news ideas of a similar calibre. That process is not always straightforward, particularly for managers with one eye on the risks ahead for this year.
“We’re pretty sanguine as to the outlook of small-caps. I think this is a stockpickers market and we have to be wary and I think that’s partly reflected in how we’re running certain positions in the portfolio,” Harlow said.
“When I look at the valuations in aggregate for small-caps, I look at the earnings growth forecast for this year (13-14 times price-to-earnings for 2017) and I don’t feel there’s much exuberance in those valuations.”
Harlow says the market represents “fair value” with earnings forecast to grow by 9 per cent, in aggregate, although there will be outliers in the market.
“The beauty of our end of the market is that it is a big universe of names and there are anomalies,” he said. “The sub-£200m area is under-researched and that is our opportunity to capitalise on that and I think that opportunity is potentially greater than normal because we have these big swings in sentiment.”
In an upcoming article FE Trustnet will explore some of Harlow’s best ideas in the small cap universe.
However, the manager reminds investors that investing in smaller companies is a longer-term proposition with companies invested in today moving higher up the market cap spectrum over several years.
He said: “The portfolio we are invested in today is made up of a number of names that over a five-year view can outperform and many will grow into FTSE 250 companies.”
Harlow took over at the start of June last year and has seen the fund return 13.76 per cent over the period, slightly behind the FTSE Small Cap (ex IT) benchmark and IA UK Smaller Companies sector.
Performance of fund vs sector and benchmark since manager started
Source: FE Analytics
The manager says singular events such as Brexit do not change his philosophy of investing and that over the next five years he expects many of the companies in the portfolio to be moving up the market cap spectrum.
The fund, which is 12.11 per cent invested in the FTSE 250, 43 per cent in the FTSE Small Cap and 39.75 per cent in the alternative investment market (AIM) has a clean ongoing charges figure of 0.84 per cent.