Small cap stocks have gone on a surge over the summer that means they have now outperformed the mid cap sector in the year-to-date and over a three-year period, according to data from FE Analytics.
Performance of indices over 3yrs
Source: FE Analytics
Widdowson says that this can in part be explained by the fact that valuations on the small cap index had lagged both mid and large cap numbers until earlier in the year. However, they still have some way to go before they catch up with the mid caps, he claims.
"Over the summer, we have noticed a lot of money coming down to the small cap spectrum and to AIM and we have seen a broad re-rating," he said.
"We have also started to see mid cap earnings growth roll over and mid cap ratings fall slightly over the summer."
As recently as April, the FTSE 250 was ahead over three years, and FE Trustnet research highlighted the heavy dependence on the index by managers in both the IMA Smaller Companies and IMA UK All Companies sectors.
Performance of indices over 3yrs to April 2013
Source: FE Analytics
The reason was a poor year and a half for small caps and a wave of money that came into mid caps during the period.
"Small caps had 18 months of net downgrades but were up around 80 per cent over the period," Widdowson said.
The shift in sentiment represents the next stage in the return of optimism to the UK economy, the manager claims.
"We have seen a big re-rating: small caps have been regarded as a risk-on asset by the market, but people have just started to buy them again."
"Growth small caps have been relatively de-rated, but we have started to see that change."
Strategic Equity Capital is a £76.3m investment trust with a genuine small cap focus.
Many of its peers have moved into larger, FTSE 250 companies due to the success of that part of the market.
Last month, FE Trustnet highlighted the quandary this created for investors who wanted genuine small cap exposure.
Strategic Equity Capital has lagged its peers over the last 12 months in NAV performance which the manager attributes to the other portfolios riding the wave in the mid caps.
"We have seen an uptick in interest over the summer as large investors look for genuine small cap exposure," he said.
However, the trust has the third-best NAV returns over three years in the sector, having made 110.4 per cent.
In share price terms it has returned 132.89 per cent over that time period compared with 48.12 per cent from the Numis Smaller Companies plus AIM benchmark.
Performance of fund vs sector and index over 3yrs
Source: FE Analytics
It is a highly concentrated portfolio: the top-10 companies account for 86.3 per cent of the trust’s holdings.
Like SVG UK Focus, an open-ended fund that FE Trustnet has covered recently, it uses private equity valuation metrics to pick its investments.
The managers look for company directors they can engage with towards an exit price and time that they have planned from the outset.
Unlike SVG UK Focus, the managers take an active role once they have invested, which necessitates taking a significant shareholding in the company.
Widdowson says that the strategy is not as risky as it may seem; although there are very few holdings, the team focuses on eliminating factors it cannot control or foresee, and, using a golfing analogy, tries to ensure that the fund "scores par on each hole" rather than a hole-in-one and a bogey.
The screens the team uses mean they often end up in the same sorts of stocks that interest private equity buyers and are frequently the beneficiaries of private equity buyouts.
Widdowson says he has seen a big pick-up in such activity, which should herald a turning of the cycle in the public markets and a new bullishness.
"January was a dud and a lot of our contacts were worried, but then in February they were all massively busy," he said.
"The reason is risk-aversion. Doing deals is taking much longer. People are preferring to a bit later and pay a bit more: most corporates have got very strong balance sheets."
The trust has a high weighting towards technology companies in the electronics, telecoms and other technological sectors, drawn there by strong niche businesses rather than any sector restrictions.
Widdowson says this area of the market is particularly open to M&A activity, as is the pharmaceuticals sector.
"Bigger companies typically cut R&D in the downturn and the quickest way to catch up is to buy it," he said.
"There has been quite a lot of bid talk around [pharmaceuticals company] Shire, for example, which is quite an investment if you are a large company, because it’s growing."
"I think M&A will continue. In private equity, debt is coming back in the sector and private to private deals are still higher value than the public sector."
Widdowson explains that public companies are trading on a discount to private equity, which is a potential sign of increasing takeover attempts of the former by the latter in the coming months.
There is also more activity in the cyclical "risk-on" growth areas of the market.
"You are starting to see secondary fund issuances coming through from more growth-orientated projects," he said.
"The stock market is improving and starting to do its job. But you have to be very careful: 70 per cent of acquisitions destroy shareholder value, so we are very selective about the type of acquisition we will back. Low leverage is important."
"We are seeing 'normal', cash-generative businesses starting to IPO," he added.
The manager says that investors often underestimate the international flavour of the smaller companies sector.
"We have lots of companies that have their head office in the UK but are really global companies," he said.
"A lot of people think of small caps as domestic, but we find plenty of global leaders and we have a high proportion of sales from outside the UK."
As much as 56 per cent of the sales of the portfolio’s companies are abroad and the trust holds just three UK-only companies.
The trust has ongoing charges of 1.29 per cent, according to the AIC.
