Small-cap investors need to get back to basics and focus on bottom-up fundamentals instead of chasing the next macroeconomic story, according to Franklin Templeton Investments’ Richard Bullas. 
The first half of the year saw a resurgence for UK smaller companies after a tough 2016 as investor risk appetite improved but many still may be too short-term focused, the manager of the Franklin UK Smaller Companies fund said.
The small-cap Numis Smaller Companies excluding investment companies index has outperformed the large-cap FTSE 100 by 5.79 percentage points so far in 2016, as the below chart shows.
Performance of indices YTD
Source: FE Analytics
This has been partly due to the reduction in recessionary fears and concerns over sterling weakness that had initially benefitted large-cap multinational companies following the Brexit vote last year.
“The investment backdrop in the UK has, in our view, remained fairly supportive. Economic and corporate news flow has been generally reassuring,” Bullas (pictured) said.
“As investor confidence has increased, there’s been a willingness to take on extra risk within the small-cap space. Investors are searching for extra returns within a generally lower-growth, lower-return environment.
“This has led to a period of strong demand for growth stocks, particularly those companies exhibiting superior growth characteristics.”
However, he warned that this return to growth and momentum investing is taking precedence over fundamentals, a risky approach for investors in smaller companies.
Last month, Columbia Threadneedle smaller companies manager Nicolas Janvier noted that it is far better to invest in consistency than looking for the one or two future large caps.
“Saying that I am there to find the next Google is like a football manager saying my job is to find the next Ronaldo. You’re always on the lookout for the next Ronaldo but by definition the Googles and Facebooks are rare and few and far between,” said Janvier.
“What you want to do as an investor is find a set of companies, especially in the smaller cap space, that are very well positioned in their industries, that are still in a position where they are going to grow at a faster rate than the economy and they are going to do that profitably.”
Franklin Templeton’s Bullas stressed that this is particularly pertinent in the current climate, with ‘amber lights’ starting to flash on some stocks trading at historically elevated valuations.
“As a result, our stock-specific investment approach becomes increasingly important in order to navigate this environment,” the manager added.
One area he has found new ideas is in the initial public offering (IPO) market, as listings in the UK – and Europe – have increased.
“The increase in the number of companies looking to list on the stock market is a marked change from the wait-and-see stance many companies adopted in the immediate aftermath of the Brexit vote last year,” Bullas noted.
“This pent-up demand has provided a window of opportunity to selectively invest in new stocks and we’ve seen a good mix of what we view as quality companies across a range of sectors, priced sensibly and attractively.”
Currently, the manager is finding the more opportunities in companies in the £100m to £500m valuation range.
“Neither too small nor too big, we believe this range offers a strong combination of attractively valued companies the wider market has often overlooked,” he said.
He highlighted the FTSE Small Cap index as a proxy for these stocks as it includes companies that are smaller than approximately £500m in size.
“The index is currently trading at around a 10 per cent price-to-earnings discount to the FTSE All-Share index,” Bullas said.
“This could be due in part to reduced liquidity at the smaller end of the market, but also could be due to the domestic skew that small-cap stocks have towards earnings.”
Indeed, as the below chart shows, the FTSE Small Cap stocks are on a significantly lower average price-to-earnings ratio than the FTSE 100 and FTSE 250 indices.
Market Valuations
Source: Franklin Templeton Investments
While market valuations offer a good entry point at this level, another positive for the sector is the improving earnings growth seen so far this year, which should continue for the remainder of 2017.
“This should play an important role in small-cap performance going forward, especially compared against the top end of the market, where the tailwind of sterling depreciation has now virtually faded,” Bullas said.
This is particularly important for the domestic names, which have largely been shunned in favour of large-cap, growth-orientated stocks with overseas earnings.
“This has resulted in a wide valuation gap opening up between growth names and domestic cyclical companies,” the manager said.
However, while from a contrarian perspective there are some really interesting opportunities in these domestic stocks, Bullas noted that it is not the right time yet to move wholeheartedly into them.
“To us, it’s a matter of balancing this valuation opportunity against the earnings risk, which we are monitoring closely,” he said.
As such, the manager of the £276m Franklin UK Smaller Companies fund is looking to diversify across a range of stocks and sectors that exhibit both growth and value characteristics.
Bullas noted: “A fast-paced and changing world presents investors with opportunities and threats, but our investing philosophy remains focused on the long term.
“Despite an environment where attentions can easily be drawn to the next big thing, we focus on the pillars of our investment foundation – company fundamentals, valuation and balance-sheet strength – to tackle the unknowns that may come our way.”
The fund, which Bullas runs with FE Alpha Manager Paul Spencer since 2012, has outperformed over five years, as the below chart shows.
The pair took over from Stuart Sharp who had run the fund for 22 years but had experienced a period of underperformance latterly; it was the worst performer in the sector over Sharp’s final five years in charge.
Performance of fund vs sector and benchmark since manager start
Source: FE Analytics
The fund has a yield of 1.1 per cent and a clean ongoing charges figure of 0.83 per cent.