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Small prey

The smaller indices can provide a fertile hunting ground if you take Aim carefully.

There is no shortage of people ready to suggest the likely dire performance of the UK smaller companies’ sector for this year.

These people made the same prediction in 2006 and even 2005. The logic seems to be that because this area of the market does well in one year, it is bound to do badly the following year.

It may surprise you to know that some people even get paid for making such a fatuous observation. Well, it takes all sorts to make a market, as they say.

At Resolution Asset Management, we do not feel that way at all. We like the small companies market. There are many reasons for our optimism on this front and not least among them is that we believe valuations are still attractive across many sectors in the market. The valuation question is a complex one and I will come back to it.

In addition, merger and acquisition activity is as commonplace in the small companies’ part of the market as in the rest of it. Private equity firms and corporates have been poring over valuations and decided there are good reasons for investing. Private equity companies rarely have a strategic angle in buying another company. They are in it for the money and, in the final analysis, so are we.

It is also true that as a result of takeovers and mergers in the UK market, there has been a net reduction of stock in UK plc. This means there are fewer shares in issue than this time last year or the year before. This money has to go somewhere and basic economics tells us that when the supply of a product is restricted, the price tends to appreciate. That is not to say all stocks will go up but that money will find itself in the more attractive, reasonably priced situations with the best potential for making money.

A partial result of this is that the IPO market is very busy. Companies are coming to the market chasing that wall of money and are particularly attracted to the Alternative Investment Market. The reasons for this are essentially twofold. First, the cost of listing is relatively small compared with the main London market but especially when compared with the US. Second, the burden and cost of regulation is light on Aim, so companies are able to seek capital from the public markets at a much earlier stage of their development. This increases risk but also increases the potential rewards.

There are now over 1,600 companies on Aim and by far the majority of new issues in London have been via this market. Much criticism has been made of the market and there is no doubt there are some stocks quoted on it that are very high risk. However, comments such as those earlier this year likening Aim to a casino are misplaced.

Aim is dangerous for the unwary but for the professional investor it is a fertile hunting ground and we now find it hard to imagine a small companies’ portfolio that does not include some sort of weighting here. In 2005, 8 per cent of Aim companies disappeared and it was 5 per cent in 2004.

Some claim that valuations in the small companies market are on the high side and it is instructive to look at the facts. According to Investec Securities, the 2007 price/earnings’ multiple for the FTSE 100 is 13 and the one-year average growth rate is 5.9 per cent. This compares with the FTSE Small Cap index trading on a 2007 p/e of 18.4. This represents a premium of 41.5 per cent to the FTSE 100. However, the one-year average growth rate expected on the FTSE Small Cap index is 21.2 per cent – a premium of 259 per cent.

Growth is not the only reason for the p/e premium as loss-making companies and those valued on a net present value basis must also be considered but such a metric is compelling.

Given these arguments, we believe the small companies’ market is likely to continue to demonstrate resilience and further strong performance.

David Clark is investment manager at Resolution Asset Management.

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