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Ground floor … going up

Good stockpicking will help identify tomorrow’s stars among the array of UK small caps

Investing in UK smaller companies offers access to an intriguing mix of mispriced and compounding stocks as well as restructuring stories for the less risk-averse investor prepared to accept above-average volatility. Investors have the opportunity to buy into the potential stars of tomorrow at the ground floor.

A good small-cap manager keeps an open mind on past failures and potentially revisits the exceptional value of stocks as they re-emerge in the wake of a restructuring or recovery situation.

One of the hallmarks of this overlooked asset class is the opportunity to gain broad exposure to the entire UK economy. The Hoare Govett smaller companies (ex investment trusts) index, equating to the bottom 10 per cent of the UK stockmarket by market capitalisation, captures a comprehensive range of commercial activities undertaken in the UK economy. It gives a wide spread across economic sectors, particularly in parts relatively under-represented in the FTSE All Share, and gives good exposure to the services sector, the bedrock of the British economy.

Even the support services sector can be disaggregated into a broad swathe of activities. Members of this sector range from Babcock International Group, which maintains the UK’s nuclear submarine fleet, to Johnson Service Group, a company that ensures many workers have spotless overalls.

UK small caps also offer an international dimension. Despite common perceptions that UK smaller companies tend to be domestically focused, this is no longer the case. The aerospace, defence, electronics, electrical equipment and general industrials sectors are notable examples where smaller listed companies are players on the global stage.

Another attraction of UK small caps is the lack of analyst coverage. Stocks with market caps up to £500m can be thinly covered by the analyst community. Smaller companies may have just one or two sell-side analysts following their stock.

Consequently, the extended universe beyond the FTSE 350 index offers enormous opportunities in terms of growth, restructuring or recovery plays, yet limited analyst coverage means the chances of discerning previously unidentified value are greater. Employing a dedicated small-cap manager also ensures that stocks residing at the lower end of the FTSE 350 receive adequate attention.

UK smaller company stocks have sparkled in recent years, with the Hoare Govett smaller companies (ex investment trusts) index delivering 19.2 per cent annualised growth over five years to June 30, comfortably eclipsing the FTSE All Share return of 12.1 per cent. More recently, the environment for UK small caps has proved a little tougher, with the index underperforming the FTSE All Share by 3 per cent for the six months to June 30.

The market has seen big swings in performance driven by supportive global economic data but tainted by the constant threat of inflation. The rise in the cost of finance has impacted on sentiment as the real cost of borrowing rises and liquidity is constrained. To some extent, this seems to be a reality check as tight conditions in the supply side of the economy impact on the price of goods and services. The UK economy is experiencing these issues in full as interest rates continue to rise, inflation is above trend and consumers continue to use savings to bring forward consumption.

Yet many smaller listed UK companies have the potential to produce good returns. There remains as much, if not more, opportunity to identify stocks on a fundamental basis that have the opportunity to outperform.

Owing to the imperfect nature of information available on smaller companies and the lack of research by the investment community, investing in smaller companies lends itself well to the art of stockpicking. Investors should not expect small caps to deliver the magnitude of returns seen in recent years but the long-term attractions of this often ignored asset class should endure.

Alan Clifford runs the Lazard UK smaller companies fund


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