Investors in small and mid-caps will see continued outperformance in 2016 compared to larger cap stocks, according to Simon Moon & Fraser Mackersie, co-Managers of the Unicorn UK Income, who believe the space will also offer more attractive income opportunities.
Smaller cap stocks and the funds that invest in them have been the standout performers in the UK market place of late with a strongly positive performance in 2015 against a backdrop of high volatility, especially compared to large caps.
According to FE Analytics, in 2015 the FTSE 250 and the FTSE Small Cap indices made 11.17 per cent and 9.17 per cent, respectively, while the FTSE 100 lost 1.32 per cent.
Performance of indices in 2015
Source: FE Analytics
On top of that, certain funds with a bias to the lower end of the FTSE All Share delivered digit gains last year and, in some cases, returned more than 20 per cent.
This trend of small and mid-cap outperformance is set continue due to a poor broad outlook for large cap stocks (particularly from the point of view of income investors), according to Moon and Mackersie – who have managed the £680m Unicorn UK Income fund for the past two years
“Smaller quoted companies are well placed to continue to outperform in the New Year in what should again prove to be a stock pickers market,” the pair said.
“The outlook for larger quoted companies’ remains mixed with dividend cover, in many cases, approaching unsustainable levels. In particular, the pressure on commodity based stocks is likely to persist in 2016. By contrast, the outlook for smaller, more domestically focused companies looks robust. “
The pair in particular, think the lower levels of dividend cover and the subsequent risk of cutting dividends will be an ongoing and increasing danger for large caps this year.
“There have been a number of high profile dividend cuts by larger quoted companies during 2015 and we believe this negative trend could accelerate in 2016.”
“Dividend cover on the FTSE 100 has fallen steadily since 2011 and is now hovering at around 1x earnings – a level that suggests dividend payments are becoming unsustainable.”
They also argue that economic fundamentals are strong for the domestic economy which should continue to lift the performance of many companies in the small and mid-cap part of the market.
“Disposable income should continue to improve as real wages increase while other inflationary pressures remain benign, thus creating a strong environment for efficiently managed businesses that are exposed to discretionary consumer spend in the UK.”
Of course most equity income investors concentrate on the large-cap part of the market, but due to reams of special dividends and the strong performance of many smaller cap stocks in 2015, many have turned their attention to this space to supplement their search for yield.
However, some have also started to argue that valuations in the small and mid-cap sectors of the UK equity market appear somewhat more stretched after their strong run but Moon and Mackersie say they are broadly in line with the valuation of larger quoted companies given their projected pay-outs for this year.
“Given increasing evidence of a return to sustainable revenue growth, generally strong balance sheets and improving cash flows; the expected growth in earnings should comfortably support current valuation levels.”
“The small and mid-cap sectors therefore remain an attractive area of the market for investors seeking sustainable and attractive dividend income.”
“We believe that our focus on profitable, cash generative, well financed, dividend paying stocks operating at the lower end of the market cap scale presents a compelling proposition for investors that are willing to accept a traditional and longer term approach to investment management.”
Since the pair became named managers on the Unicorn UK Income fund along with John McClure (who died later that year), the portfolio has returned 9.43 per cent compared to the IA UK Equity Income sector average return of 7.39 per cent. Over the same period the FTSE All Share gained 0.11 per cent.
Performance of fund sector and index over managers’ tenure
Source: FE Analytics
An investor putting £10,000 into the fund at the time would have since seen a pay out of £925.71.
Pay-out on £10,000 over managers’ tenure
Source: FE Analytics
While two years is, for some, too short to judge the outcome of a fund’s performance, it is worth adding that the pair worked closely alongside McClure for a number of years before being named managers on the fund and claim “to be fully indoctrinated” into his process.
The fund is first in the sector for total return over five years and has the sector’s highest Sharpe ratio, which measures risk-adjusted returns and the highest alpha relative to the FTSE All Share.
To try and continue that outperformance, Moon and Mackersie have been steadily increasing exposure to the domestic economy over the past year.
“The UK consumer is in a strengthening position as a confluence of factors combines to increase discretionary spending power: rising disposable income; imported deflation through the falling price of oil; and falling prices of consumer staples,” they said.
“Consumer confidence should therefore continue to improve while unemployment has now fallen to pre-crisis levels.”
Unicorn UK Income has a 0.81 per cent clean OCF and yields 3.58 per cent.