Investors should beware an emerging bubble in small-caps stocks, according to GVQ’s Stuart Widdowson, manager of the highly successful Strategic Equity Capital investment trust.
Over the longer term, investing in UK small-cap equities has been a very gratifying job compared with large-caps stocks thanks to the sky-high returns from the small and mid-cap parts of the market.
According to FE Analytics, the mid-cap space has led the charge over the past 30 years as well as over the past 10 years. However in the past five years it has been small-caps where the most money has been made.
Performance of indices over 5yrs
Source: FE Analytics
In 2015 so far this trend has been very much apparent with the FTSE Small Cap index almost tripling the gain of the FTSE 100 with a 10 per cent rise. This has provided much strength for investors who have seen weakness in most other parts of the market.
Performance of indices in 2015
Source: FE Analytics
Widdowson, whose trust is largely invested in small-caps, has been no exception to the rally in this area and sits top decile min the IT UK Smaller Companies over the past one, three and five years. The trust is also the best in the sector since Widdowson took over in 2009 with a hefty 552.46 per cent total return.
Performance of trust, sector and index since June 2009
Source: FE Analytics
However, while the manager is still bullish that he can make decent returns over the medium term he thinks the good run has led to some signs that the market is headed for an event akin to the tech bubble of the early 2000, which devastated many investors once it burst.
“If you take the market for small-caps broadly, we are looking at mid to high single-digit returns and more where there is M&A and free cash flow. However it is very much predicated on companies hitting their numbers,” he said.
“However, we think there is risk that the market pushes the really high growth companies way, way beyond fair value. It is hard to know what the next tech boom will be but it is very likely that whatever happens towards the end of the cycle, we will definitely see an absolute blow-off in small companies’ valuations.”
“Are we in bubble territory yet? I don’t think so but it would not surprise me if in the next three to five years we see smaller companies become quite overvalued. Part of the reason for that is the underlying liquidity it not all that great – sometimes you will want to sell but can’t get out.”
Widdowson’s £135m portfolio is invested primarily in small-cap equities, however, investment team at GVQ say they are unusual compared to their peers for using “private equity techniques” in the stock selection process.
It has done very well over the past one, three and five years both in terms of price and total return, and the trust’s parent company GVQ has recently been bought by another IT, Rothschild Investment Trust.
Analysts at broker Winterflood Securities tipped Strategic Equity Capital as a trust to watch in 2015, saying that while it carries high stock specific risk due to a concentrated portfolio, Widdowson and the rest of the team have a unique and justifiable style that has paid off.
“We like the manager's well considered investment approach, which applies private equity techniques to public markets,” the analysts said.
“The team at GVO IM also actively engages with management teams to bring about change and improve corporate governance. However, they prefer to do so discretely and believe that aggressive activism can be counterproductive.”
“The investment team is supported by an ‘industrial advisory panel’, which consists of five individuals with complementary skills and M&A experience, including Sir Clive Thompson.”
Widdowson says despite his concerns of a bubble and expectations of lower medium-term returns, there are plenty of reasons to be positive on the small-cap space.
“Value can be found if you are willing to look for it, particularly if you can engage with the company’s management to help unlock it. We also see some interesting opportunities in momentum plays ‘gone awry’ that have been overly downgraded but whose base case remains attractive,” he said.
“There also remain a few opportunities among higher quality, higher margin businesses some of which have fallen out of favour, although valuations are not uniformly attractive.”
It should be noted that the strong performance of the trust has led to it currently being on a 4.6 per cent premium, having moved from a huge 25 per cent discount back in 2012.
The analyst team at Winterflood say that they think this premium is sustainable, particularly for longer term investors.
The trust has an OCF of 1.33 but also charges a performance fee which bumped fees up to 1.65 per cent at the last measure.