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Cap of good hope

Smaller companies are not an area in favour, considering they are often the biggest victims of a struggling economy.

However, some managers are favouring the smaller end of the UK market at the moment, despite the traditional bearish view on the asset class in times of economic strife and the fact that it is often plagued with liquidity issues in a falling market.

Artemis UK special situations manager Derek Stuart has been eyeing opportunities lower down the market cap scale, taking the large-cap weighting in his fund down to some 50 per cent.

So far this year, UK mid-cap portfolios and those with small-cap biases are among the best performers in the entire onshore fund universe.

According to Trustnet figures, the best performer in the market over the year to March 4 is the £1.4m Close special situations fund, listed in the Investment Management Association’s UK smaller companies sector, with a return of 23.4 per cent. It is followed by the UK all companies vehicle, Manek growth, which has a number of small caps among its top 10 positions, and then another smaller companies fund, Close Beacon Investment.

In the UK all companies sector over the three months to March 4, nine out of the top 20 portfolios in terms of performance all had mid-cap mandates while most of the remaining 11 were opportunities or alpha portfolios with small and mid-cap exposures. Only 23 funds in the 336-strong peer group did not post losses over the three-month period. Despite the sensitivity of smaller companies to the state of the economy, particularly as the number of companies headed into default mounts, there remains an argument for the smaller end of the UK market.

For one, so far in the current economic climate, it has been some quite big companies – predominantly banks – which appear to be the ones suffering most in current market conditions. Also, some managers note that while small and mid-cap companies look vulnerable to potential collapse, they could also be merger and acquisition targets or they could be the beneficiaries of bigger companies going under by the sudden accumulation of market share as their bigger rivals suffer from heavy debt exposure.

Liontrust Intellectual Capital Trust co-manager Anthony Cross says: “Many investors head for big and so-called defensive stocks during an economic downturn but big has not necessarily proved to be best in the current downturn. The downturn has also illustrated the importance of investors not generalising about small-cap stocks as they can still find plenty that are growing their earnings and profits.”

Thames River Capital multi-manager Robert Burdett says while he and his co-manager Gary Potter have had no dedicated small-cap funds in their portfolios for more than a year, some managers are seeing the benefits from their individual exposures.

He says: “In a market where one of the key risks is liquidity, this area remains vulnerable. Equally, banks are taking no prisoners when it comes to short-term lending facilities, to which small caps are typically more exposed. However, these are generalisations and we are happy for our special sits and multi-cap managers to start sorting the wheat from the chaff on our behalf and when we see them start to get excited, we may well add a dedicated small-cap fund.”

He points out that one of its holdings, Rensburg managers’ focus, is doing well. According to the fund’s latest factsheet, the portfolio has less than 50 per cent invested in bigger companies, with around 20 per cent in Aim stocks and 26 per cent in the mid 250 area of the market.

Stuart’s higher small and mid-cap weighting in his special sits fund was done as he spied opportunities in the sector, an attitude echoed by his small-cap colleagues Mark Niznik and John Dodd. With share prices in the smaller end of the market halving last year, all three see prospects for some smaller companies to see better than average growth.

Niznik says: “As share prices have been falling, John and I have been getting more excited about the prospects. We have been tracking quality companies over the past few years and now we are able to buy these companies at pretty much bargain basement prices. We see the opportunity to go on a shopping spree in 2009 which should pay substantial dividends in future years.”

Not all managers share this enthusiasm and believe the risks remain high outside big and mega-cap stocks. Francis Brooke, manager of Trojan income and co-manager of Trojan capital, has a select few mid-cap positions but notes that the capital fund has just 15 per cent at the lower end of the market compared with close to 50 per cent last year. He believes the exposure these firms have to the domestic economy means they are not resilient at this time and still represent too much risk and uncertainty.

He says: “We believe a market rally will be led by quality companies, not recovery stocks.” He concedes that mid-caps have performed better than the FTSE so far this year but he is still wary, which is in keeping with his low volatility style of management.

Brooke also indicates concerns about liquidity in the sector, noting that trading out of smaller company positions may be difficult in an already volatile market. He says: “Across the market, liquidity in general is tighter and the spreads for trading are wider, making it difficult enough to trade on even some of the bigger companies.”

Brooke says it can take longer to liquidate a portfolio in the current market, a situation that would only be exacerbated in smaller cap stocks.

Despite the risks, those favouring the small end of the market are certainly doing one thing – instilling some hope that there are growth opportunities that can still be found in what appears to be an income, defensive and value-dominated market environment. Income will be the main story in the coming months but those seeking capital growth may not be entirely out of opportunity.

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