Smaller companies have had a phenomenal run in recent years. This year, the market has weakened owing to a combination of global factors: fears over the end of quantitative easing, tensions between Russia and Ukraine, slowing growth in China and deflation risk in Europe. As I write, geopolitical issues in Iraq are causing further problems.
Many commentators have predicted the market is due a correction. In reality, it is impossible to foresee the direction of markets but, in my view, setbacks present opportunities.
Perhaps it is not surprising we have seen a correction in the share prices of smaller companies, given their performance over the past few years. The FTSE Fledgling index alone was up 48.4 per cent in 2013, with the FTSE Small Cap index up 43.9 per cent. This follows on pretty good returns for 2012 too.
Funds investing in small and medium-sized companies, such as Harry Nimmo’s Standard Life UK Smaller Companies fund, have been affected by the setback. Highly rated growth stocks, many of which Nimmo favours for their sustainable earnings prospects, have been affected quite severely. Such stocks were impacted further by a concerted risk reduction by investors. I recently caught up with Nimmo and he points out some of the more cyclical, or economically sensitive, areas of the market, such as housebuilders, had reached multi-year highs. A period of low interest rates has helped lower quality businesses as it has offered the opportunity to pay down debt, boosting profit margins. However, this does not detract from the cyclical nature of these companies and he argues many investors have forgotten this fact.
Perhaps this has been reinforced more recently by Mark Carney’s latest speech with a view that interest rates may rise this year rather than next. Nimmo’s focus is on quality; given the portfolio is not skewed towards cyclical businesses, perversely, a rate rise, if anything, would act as more of a help.
The earnings expectations for most of the fund’s holdings remain intact and many still offer significant dividend growth. However, Nimmo admits a handful of stocks have seen modest earnings forecast downgrades but have been accompanied by severe share price falls. For example, after a strong run in 2013, Asos has undergone a savage attack since March.
It might appear a little odd that some larger stocks such as Asos and Rightmove are held in a smaller company portfolio. The reason is that Nimmo is keen on running his winners. He is happy to sit tight as a company progresses through the indices, from a smaller company right up to the FTSE 100. This allows the fund to fully capture the growth of some of the UK’s most successful businesses.
He has been taking profits from his holding in Asos for quite some time although he tells me this is the third time on his watch that the share price has fallen by half. He realises now is the time to recycle profits into new ventures, having made 33 times his money on this stock on average.
New names include Poundland, purchased upon its recent listing to the UK market. Nimmo makes a good point that the starting valuations for many IPOs coming to the market are much too high. We have seen significant inflows into the smallest end of the UK market, which happens to be a particularly narrow part of the market. However, valuations in this area are beginning to come down.
Mark Dampier is head of research at Hargreaves Lansdown