At the start of 2009 markets were in freefall, there were concerns about financial and economic meltdown and the last place you wanted exposure to was smaller companies with their higher risk and greater exposure to the domestic economy.
A year on and small companies, as represented by the FTSE Small Cap (ex Investment Trusts) delivered a return of 58.2% for 2009, outpacing the FTSE 100 which returned 27.9% over the same period and representing the best absolute performance from small companies over the last 16 years. Even the much-maligned FTSE AIM All Share Index joined in with a strong year returning 68.3% by total return. This could not have proved a stronger contrast to 2008, when small companies returned – 50.4%, their worst performance in the last 16 years.
In the context of these significant returns and the reversal of sentiment among small caps, where does the investor go now? Have small caps run their course and should investors move on? Where can investors look for the best returns in the small companies market?
On a broader level, despite the strong performance in 2009, valuations still do not look stretched and the FTSE Small Cap Index remains 40% below its peak of April 2007. Though there are many valuation anomalies and the valuation discount to the main market has closed, the FTSE Small Cap is on a slight discount trading on 10.7x forward PE (ex loss makers) versus the FTSE All Share on 11.9x.
Despite strong performance, there is reason to expect positive returns from the small-cap universe in 2010. However the drivers for this performance will be significantly different from 2009. Macro calls dominated 2009 with long cyclical/highly geared and short quality/defensive being the key to the strong performance with the trend being most marked in Q2 and Q3. This year will see greater differentiation by the market at a stock and thematic level.
In summary, 2010 is likely to see more moderate returns from the UK small-cap market. Unlike 2009, 2010 is likely to see more differentiation across the market and the key themes to build a portfolio around include those businesses able to provide above average earnings growth despite economic headwinds, examples of self help where managements are able to generate earnings growth through internal actions and, lastly, dividend payers.
Toby Belsom and Robin West, managers of Aviva Investors UK Smaller Companies fund
