After a strong run of outperformance, can UK small cap equities continue to rise on the back of the recovering economy or are valuations beginning to look stretched?
So far in 2013 the FTSE Small Cap Index is up by around 26 per cent, compared to approximately 17 per cent for the FTSE All Share and 15 per cent for the FTSE 100.
The sector also continues to be a favourite with investors too. Investment Mangement Association retail sales figures ranked UK Smaller Companies in the top 10 selling sectors for July, with net sales totaling £100m.
Recent data showing signs of recovery in the UK economy has prompted some small cap managers and advisers to argue the sector will see upgrades, while others say valuations in some areas look expensive and attempt to search out value.
Old Mutual Global Investors UK small cap manager Daniel Nickols says improvements in the UK economy will continue to bring benefit to sub-sectors within the small cap space.
Nickols highlights signs of increasing consumer confidence in the UK as a driver for a sustained uplift within consumer facing stocks. He says: “Consumer-oriented sectors in general look likely to continue to outperform.
“If you look at forecasts in those companies, I think expectations for what the improvements to the UK consumer can deliver to these companies is pretty low.”
UK housebuilders are one area of the small companies sector that has shown signs of share price weakness in the last few months following a sharp rise in share price sparked by the Help to Buy announcement in the Budget earlier this year.
However the £738.7m OMGI UK Smaller Companies fund continues to run an overweight position in UK housebuilders, says Nickols, on the belief that upgrades and structural stories can allow the sector another run.
He adds: “After a bit of a pause over the summer months, I think this sector can go again as we begin to see upgrades come through. The story isn’t over.
“The reasons for this are primarily structural rather than cyclical. The land buying market still seems relatively uncompetitive for the quoted operators. We think this story will play out over a lengthy time horizon.”
Henderson Global Investors UK Smaller Companies trust manager Neil Hermon also says UK housebuilders can continue to benefit from improvements in the wider economy, with the rise in their valuations marking a return to “normal levels.”
He adds: “If you look forward into 2014-15, I think they have got another twelve months plus performance to go. So we are relaxed about our position here.”
Economic data has also supported strong performance in consumer facing small cap stocks, says Hermon, prompting a number or new additions to the trust including online retailer N.Brown and Cineworld.
Despite being optimistic about further gains in areas of the smaller companies sector, Hermon says the UK equity market overall, including small caps, now looks “more fair rather than cheap.”
The £78.2m Swip UK Smaller Companies co-managers Andrew Paisley and Gregor MacDonald argue that valuations of many strong performing small cap stocks now look expensive when compared to the sector overall.
MacDonald says: “There are definitely bits of the market that have had a run and are now looking toppy. It is not easy to see where and what we would like to put our money into.”
Paisley highlights opportunities further down the market cap scale within smaller companies. He says: “We are finding value down the market cap where valuations look a whole lot better. The scale of the sector means there are almost always ideas.”
But MacDonald adds at this end of the market cap it is necessary to ask if valuations are low for a reason and be sure that companies are truly good value and are just being ignored by the market.
Nickols argues certain stocks that appear expensive now will go on to look cheap on a longer term view. He says: “Some of the consumer ‘survivor’ names like Dixons may look expensive.
“However the benefits that are due to flow through over the next two to three years from being the last man standing amongst competitors will make it look cheap.”
Charles Stanley Direct head of investment research Ben Yearsley points out that small caps tend to trade on a premium against an improving economic backdrop, but also points to buying opportunities in possible market dips.
He says: “I would not necessarily say the sector is looking expensive. You always end up having to pay for growth in small caps. However over the long run they generally do well and outperform and there will definitely be upgrades.
“Also this is not a straight line recovery, there will be dips and troughs. So even if today is not the best time to buy, there will be opportunities when people get a bit nervous, to buy back in again at good prices.”
Hermon also addresses a wider issue that could potentially affect further gains in small cap equities and the market as a whole. He says: “We have not seen a lot of earnings growth in corporates yet.
“We need to see economic growth translate into earnings growth of corporates in order for UK equity markets to make further gains.”