After a period of exceptional growth, do small and medium-sized companies still offer the same investment opportunities going forward? Standard Life Investments' Mark Niznik takes a look
Returns in small and mid-cap companies have been spectacular over the past two and a half years as markets have rebounded strongly and the UK economy has displayed steady growth. These companies have significantly outperformed larger companies in performance terms. Furthermore, the valuation discounts that small and mid-cap companies have traded on in the past, have disappeared to the extent that they are now on premium ratings.
Three years ago, there were several reasons to be highly positive about future returns from these companies. For instance, valuations were attractive and we were seeing a lot of company directors buying shares in their own companies. However, following a period of strong performance, these supporting factors have altered.
Share prices have roughly doubled in this area over the past three years and the valuations of these shares are now around their highest levels in the past 25 years. Small/mid-caps now trade on a 15% P/E premium to larger companies - this has been the case in only five of the last 25 years and director buying has also now moderated.
We believe the overall environment will continue to be supportive for UK equities and they remain on course to provide investors with healthy returns relative to other forms of investment. Global issues such as the price of oil and the dollar will continue to have an impact on investor confidence. Nevertheless, we believe a fully researched portfolio of small and mid-cap company shares offer the potential for strong performance if investors are prepared to take a medium to longer-term investment view.
The earnings growth potential of small and medium-sized companies should allow them to outperform their larger brethren over the medium to longer term. It is easier for a smaller entity to grow at the same percentage rate than a larger company given greater scale economies being achievable. Small and medium-sized companies are more flexible and quicker to react than large caps. In addition, smaller companies tend to have proportionately greater management ownership so their interests are aligned better with investors compared to larger companies.
The historic performance record of small and mid-cap companies versus larger companies supports this argument with investors making more money in small/midcaps in twice as many years in the past 50 years than in larger companies.
While it is clear that capital progress will be more difficult for small and mid-cap companies over the short-term, particularly if the price of crude oil rises further and all that that means for inflation, interest rates and business confidence, the sector continues to be supported by bid activity.
The past two years has seen a marked increase in mergers and acquisitions. In 2005 alone we enjoyed the impact of bid activity on the UK Opportunities fund involving the likes of Ashtenne (cash bid from Warner Estates), Merchant Retail (cash bid from A P Watson), Scottish Radio Holdings (cash bid from EMAP), Easy Surrey Holdings (private equity cash bid) and Domnick Hunter (cash bid from Eaton/Parker Hannifin). Given healthy balance sheets and historically low interest rates, we believe that the necessary conditions are in place for companies to continue creating earnings growth through acquisitions - whether as a means of boosting earnings by releveraging, or in order to create concrete revenue or cost synergies.
A PROCESS THAT PROTECTS
We are now in the middle stages of an economic cycle. The easy recovery gains have been made and investors are starting to look for robust business models, which display top line sales growth that can withstand a slowing UK and world economy over the next couple of years. This brings with it a more modest rate of progress in terms of capital gains as well as a market environment that should favour a process dedicated to meticulous stock selection.
Our Smaller Companies Team follows a process that involves spending as much time as possible with the companies being considered for investment. Last year we held 500 one-to-one meetings with the top management teams of companies across the country. The aim of these intensive meetings is to ensure that the company displays a competitive advantage over others in its market place and a sound financial track record.
If the company meets these criteria, we then ensure that we invest at the right time, at the right price. Once invested in a company, we rigorously monitor price changes, news flow and risk.
The UK Opportunities fund is driven by stock selection and does not follow current stock market fashions. For example, the fund does not currently have any exposure to oil & gas exploration companies, mining companies or online gaming companies. We feel that such stocks have been given high prominence by investors and this has subsequently pushed their valuations to levels that may not be sustainable.
Given the marked rally in small and mid-cap shares during 2005, we reduced a number of high risk/reward investments in our UK Opportunities Fund, as we believe that investor risk appetite is heightened and may fall in the future. This can be seen from the sales of holdings like Cambridge Silican Radio, Wolfson Microelectronics, XP Power & Trafficmaster.
Meanwhile, recent investments have included companies whose earnings are either covered by good long-term order books or where recurring earnings are high. These include Northgate Information, Mouchel Parkman, Serco, Whatman and Datamonitor.
While small and mid-cap companies can not continue to perform at last year's heady levels, they do still offer real growth opportunities, which can be exploited using a robust stockpicking approach. For those investors with medium to long-term investment objectives, the UK Opportunities fund is a compelling option. In particular, it is an ideal and complementary investment for those clients who already tend to have disproportionately high exposure to larger companies through their pension and mortgage repayment vehicles.
Ten largest holdings as at 31-12-05
Holding Percentage of fund
Northgate 2.36%
Incisive Media 2.30%
Balfour Beatty 2.20%
Serco Group 2.15%
Renishaw 2.11%
Victrex 2.05%
Meggitt 1.98%
Northgate Info Solutions 1.94%
Shaftesbury 1.89%
Expro Intl Group 1.87%
Asset Allocation as at 31-12-05
Holding Percentage of fund
Cyclical Services 36.80%
Financials 13.50%
Information Technology 8.60%
Basic Industries 8.60%
General Industrials 22.60%
Cyclical Consumer Goods 1.10%
Non-Cyclical Consumer Goods 4.60%
Resources 1.90%
Cash 2.30%
