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Sector focus: Cashing in on the UK small-cap bounce-back

Following a sharp drawdown in the aftermath of the country’s decision to leave the EU, UK smaller companies have staged a strong recovery.

Stockmarket-Stock-Market-FTSE-Performance-700x450.jpgFollowing a sharp drawdown in the immediate aftermath of the country’s decision to leave the European Union, UK smaller companies have staged a strong recovery.

Sterling’s initial depreciation benefited the earnings of larger companies, with a higher proportion of their revenues coming from overseas, leading to their outperformance relative to their smaller, more domestically-focused counterparts through the end of June 2016.

But the picture today looks somewhat different, with the FTSE Small Cap ex Investment Trust index outperforming the FTSE All Share by more than 10 percentage points in the 12 months since.

That said, the referendum clearly increased the uncertainty surrounding the UK economy and investors have responded by withdrawing money from the small-cap space.

Aggregate net flows from open-ended UK small-cap funds have been negative in each quarter since, with the total net outflow over the last four estimated to be in excess of £1bn.

Fund of the month: The small-cap strategy that packs a punch

This is another example of poor investor timing. For while the bounce-back has encompassed the strong performance of UK small caps broadly, active funds in the sector have performed even better. The average UK small-cap fund has outperformed the FTSE Small Cap ex IT index by almost eight percentage points in the year to the end of June.

The turnaround began in the second half of 2016 and outperformance has accelerated further this year, with positive stock selection driving those active returns relative to the index.

Fevertree Drinks has been one of the largest individual stock contributors to fund performance, with a rise of more than 50 per cent year to date. The average fund’s underweight position in oil and gas has also proven beneficial for active returns.

Over the longer term, active UK small-cap funds have added value over the FTSE Small Cap ex-IT index, with outperformance of almost three percentage points per annum, on average, over both the 10- and 15-year periods.

However, there remains significant dispersion between the returns of the best and worst performing funds within the sector, underscoring the importance of robust fund selection. Here we highlight some of those rated positively by Morningstar analysts.

Fund picks

Old Mutual UK Smaller Companies has been managed by Daniel Nickols for more than a decade. His involvement goes back even further to 2001 working alongside previous manager Ashton Bradbury. The fund incorporates a top-down element alongside bottom-up stock analysis, and Nickols has a flexible approach with no bias towards value or growth. Instead, he looks to respond to economic and market conditions. The bottom-up research seeks to identify companies with the potential to be re-rated as a result of strong growth and greater financial stability. Morningstar Analyst Rating: Gold.

River & Mercantile UK Equity Smaller Companies is managed by Philip Rodrigs, who assumed responsibility for the fund in September 2014. Rodrigs had previously built a strong track record as manager of Investec UK Smaller Companies. An initial quantitative screening helps identify stocks worthy of further analysis, which can be categorised as growth, quality, recovery or asset-backed. Rodrigs invests across all four but the fund generally tends to have a tilt towards growth. The fund typically includes significant allocations to stocks lower down the market-cap scale and to Aim-listed companies. Morningstar Analyst Rating: Bronze.

Liontrust UK Smaller Companies is managed by Anthony Cross, with support from Julian Fosh, Victoria Stevens and Matt Tonge. Cross has managed the fund since 1998 and was joined by Fosh in 2008. The investment process focuses on the importance of the intangible assets of a company, emphasising intellectual capital, distribution channels and repeat business. This leads the fund to have a natural bias toward the less capital-intensive, people-focused businesses, such as support services, technology and media. Morningstar Analyst Rating: Bronze.

Samuel Meakin is analyst, manager research, at Morningstar

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