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Watch out for the quiet ones

There seems to be a strong tendency for UK investors to write off their own stockmarket and economy very quickly. Perhaps it is because we are so close to it and see the damage that politicians on all sides do – so why would we invest? Yet despite the politicians and bureaucrats, many UK companies prosper.

There is a natural inclination to consider the big firms making up the FTSE 100 but one sector that really rewards the hard-working stockpicker is smaller companies. Ask anyone in a fund manager’s marketing department and they will say UK small caps do not sell. This is extraordinary given the number of high-calibre managers in the area, some of whom I have highlighted before in this column. It is also a slightly confusing sector because some smaller companies funds have a greater proportion in what are really medium-sized companies.

One fund that is genuinely small-cap is Investec UK smaller companies managed by Philip Rodrigs. The fund is benchmarked against the FTSE Small Cap index, although it has the ability to run its winners as they progress into the FTSE 250, where they can often get an extra leg up as they appeal to a wider investment audience.

Investec has its own screening process known as the four-factor model, which it runs weekly to narrow down the universe of around 800 stocks available to the fund. It looks to identify higher than average quality companies, better than average value, an improving expectation of current profitability and current share price strength.

These four factors, if found together, tend to be strong indicators of future company strength. However, no system is perfect and, like many, it tends to work less well during inflection points in the market when momentum shifts from positive to negative – or vice versa.

In the first quarter of 2009, the system suggested buying strong, defensive stocks. The market was also writing off indebted firms as it was thought they would struggle to refinance. But Mr Rodrigs found that companies on the ground were seeing things differently.

Good companies could get finance, but at a higher price, and there was little chance of them going bust. Therefore, he ignored the model and positioned his portfolio far more aggressively – using 10 per cent of the portfolio for much higher volatility plays that should increase far more than the market average. There is little doubt that he has been well rewarded by taking this initiative as the market rebound in this area was very strong.

The fund has had a strong 2010, up by 32 per cent year to date. Given such strong performance, you might think the story is over but Philip Rodrigs believes there is significant potential from here and likens the present time to August 2004, when there was a slight pause in the market just before it took off again.

Encouragingly, he says corporate profitability is very strong and valuations are inexpensive. He believes his own portfolio is on an average p/e ratio of nine and with the market trading at around 10 times, he can find plenty of cheap companies he wants to buy.

While I remain a fan of the big, defensive blue-chip stocks for their excellent yields in low-interest-rate world, investors should not ignore this part of the market. Many of these smaller companies are global players in their respective niche areas and I think we will see plenty of merger and acquisition activity going on.

Well run, solid companies have little problem in gaining access to funds if they need it and they make attractive targets for larger firms, both at home and overseas. Many investors are loading up on emerging markets (an area I have always liked) but UK small caps have been quietly providing similar returns but without ever really becoming fashionable, something I think investors should take advantage of.

Mark Dampier is head of research at Hargreaves Lansdown

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