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Small change

Having seen a strong bull run in the first half of the decade, stocks in the UK smaller companies sector have recently been overshadowed by their bigger count-erparts following a marked slow down in the economy.

Statistics from the Investment Management Association reflect the slow-down, with the average UK small-cap fund returning 81 per cent on a three-year basis at the end of 2006 compared with 37 per cent now. The one-year figures for the average fund show a loss of 16.4 per cent.

Many IFAs are steering clear of UK small caps, pointing to the fact that they tend to be highly cyclical and domestically orientated, meaning they are largely exposed to boom and bust returns.

Chelsea Financial Services managing director Darius McDermott says there are opportunities but he can see the rationale behind avoiding the sector for the present.

He says: “It is unlikely that UK smaller companies are likely to outperform in the next 12 months. It is a different economic climate and they are still domestically focused. At the moment, I have no exposure to small caps at all as I prefer to choose managers using a multi-cap attitude in this environment.

“It is still too early for a contrarian attitude as they are still in a downturn, though a smaller focus on domestic orientation may mean opportunities.”

However, Hargreaves Lansdown head of research Mark Dampier thinks that opportunities may arise and that moving out of the sector lock, stock and barrel is not the way to go as the mass of smaller companies available and, more important, the fact they are not subject to constant analysis as with bigger counterparts, means opportunities.

“I look at the likes of the Standard Life and Old Mutual UK smaller companies funds as good examples of managers who can find these opportunities and buy tomorrow’s bigger companies today,” he says.

In the past year, Standard Life UK smaller companies fund has lost 8 per cent under the management of Harry Nimmo while the sector has lost more than double that amount. Old Mutual UK smaller companies fund has lost 11.7 per cent under the management of Dan Nickols.

Dampier is also in strong agreement that UK small caps are no longer tied to the UK alone.

He says: “Take Nimmo’s fund, for example. That has access to Paddy Power, which is only 45 per cent UK, and JKX oil and gas, which is a Ukranian company based 100 per cent overseas.”

However, T Bailey fund manager Jason Britton warns that the small-cap sector could be hit by rights issues following Royal Bank of Scotland’s decision to raise £12bn in April.

Britton says other banks could follow RBS and he believes small caps are vulnerable due to their dependency on bank financing.

He says: “Smaller companies are often dependent on bank financing for expansion and growth plans. If the ongoing problems in the credit markets prevent these companies from refinancing their funding as facilities expire, then they will probably need to turn to shareholders to provide ongoing support in the form of a rights issue. This will be bad for share prices in the smaller companies sector.”

But BlackRock UK smaller companies manager Richard Plackett says: “What has been playing out in the last nine months is that companies with lots of debt have seen their shares trade pretty poorly and, as a result, rights issues have come about. But what we are seeing is rights issues from the biggest companies like RBS to the smaller firms. They will affect companies across the spectrum.

“We run on a strict portfolio discipline and, if anything, our portfolio diversification has increased marginally in the past 12 months, because in a difficult economic environment you have to be doubly sure that you are in companies that can trade strongly.”

“For the next six to nine months, it is all going to be about resilience and growth stocks but rights issues will be one way that we increase our exposure to cyclical areas of the market.”

Jupiter UK smaller companies fund manager Richard Curling says that credit problems have seen investors move away from small caps in a bid to find greater quality and liquidity but some of these markdowns have been indiscriminate and are leading to opportunities.

“Uncertainty persists as to the degree of slowdown in the economy but sentiment is expected to remain negative overall. In addition, private equity activity, which supported small-cap stocks in the past, has declined following the credit crisis. However, inter-company merger and acquisition activity seems to be filling the gap here and should provide some support for the market.”

Curling believes small-cap stocks should recover against the large caps in the long term but says the team remains cautious until the effects of the credit crisis have begun to clear.

“Against this backdrop, we continue to focus on companies with strong balance sheets, sustainable cashflows and businesses that are less exposed to the economic cycle than average,” he says.

Credit Suisse smaller companies manager James Chapman says: “We retain a cautious outlook on the UK economy, where the housing market is rapidly deteriorating. This latter development will inevitably have a knock-on impact on consumer confidence.

“However, despite these troubling developments, the UK small-cap market has speedily discounted a lot of bad news as shown in the steep decline of share prices from the peak levels of June 2007.

“Furthermore, the lack of liquidity in small-cap shares has exacerbated the recent price declines, creating some excellent buying opportunities for investors.”

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