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Thinking small

There is room for optimism for UK smaller companies if one looks at year-to-date total returns to April 20. The FTSE 100 was down by 8.71 per cent but the small-cap indices were all up.

The Hoare Govett ex investment trusts rose by 16.2 per cent, the FTSE small-cap index ex investment trusts was up by 16.89 per cent and the Aim Allshare saw a 15.11 per cent rise.

Although we have had rallies before, several factors make this more interesting.

First, after a raft of profit warnings at the end of 2008, earnings’ forecasts now seem more realistic. More firms across a greater number of sectors than before are forecast at near-trough margins relative to their own history.

Second, valuations also appear more attractive. Nine per cent of FTSE 100 names are rated below six times price/earnings multiples but 23 per cent of the Hoare Govett and 34 per cent of the FTSE small-cap names are trading below six times p/e multiples.

Third, trading is no longer worsening in some early-cycle domestic consumer sectors.

Furthermore, there has been a change in the perception of funding available to businesses.

Last month saw several company announcements confirming that banking covenants have been eased.

These announcements have prompted share prices to rally from an “Armageddon” scenario for refinancing to one where rights issues are viewed as possible, probable and potentially profitable.

Although the future holds a period of austerity and fragile trading rather than strong recovery, there is room for optimism on the valuation of many companies within the small and mid-cap sector as earnings’ expectations stabilise and the financial risk discount narrows.

What type of stocks are we favouring? We have been evolving the Aegon UK smaller companies fund from an extremely defensive positioning to a more balanced portfolio.

In the third quarter of 2008, the fund invested in relatively strong balance-sheet consumer cyclicals, taking advantage of the depressed valuations. Housebuilder Bellway, pub company JD Wetherspoon and retailer Dunelm were added.

All these companies have subsequently experienced some signs of stabilisation in earnings’ forecasts and all of them have been re-rated.

A more recent purchase was LSL Properties, bought in January 2009. The company qualified as a sector winner due to market-share gains but we also feel it had been undervalued. Profits had been hit hard in the estate agency business due to unsustainably low housing transactions.

In addition to consumer-related recovery stocks such as these, we retain overweight positions in core growth stocks such as Connaught, Chemring, Craneware and Telecity.

These stocks have not all kept pace with recent gains in the FTSE small-cap index but, as the market has traded into risk, we believe that the strong underlying growth will be rewarded over time.

We remain cautious both on capital expenditure- related and financially distressed stocks.

Capital expenditure tends to be late-cycle and we feel that the effects of reduced corporate spend is not yet fully in forecasts.

Financially distressed stocks have seen valuations surging from extremely low levels in response to a change in the market’s perception of their ability to refinance.

However, we are confident that many of these stocks have debt levels that can only be solved through dilutive rights issues.

Elaine Morgan is fund manager of the UK smaller companies fund at Aegon Asset Management


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