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magazineDon’t turn your back on small caps as markets fall
As the UK continues to step lightly through the coronavirus pandemic’s social distancing minefield, many investors have turned their back on the small cap space. This is a mistake.
We can understand why small caps might not appeal to everyone at the moment, given this space can include unproven business models and fragile balance sheets. It can also be harder to sell small cap shares when you want compared to larger companies.
However, successful stock pickers have managed to reduce portfolio losses this year by having stakes in more resilient small cap businesses.
Data shows parts of the small cap space are holding up relatively well versus the broader UK stock market, as defined by the FTSE All-Share index which is down 23% year-to-date. Twenty one UK small cap equity funds and investment trusts have this year fallen by less the FTSE All-Share, out of a total universe of 75 funds.
The best performer is Miton Smaller Companies Fund (B8JWZP2) whose shares have are down 12.3% between 1 January and 9 April 2020. Other strong performers, on a relative basis, include Octopus UK Micro Cap Growth (BYQ7HP6), down 13.3%; and Liontrust UK Smaller Companies (B57TMD1), down 17.3%.
Nonetheless, it is important to take a balanced view by pointing out that parts of the small cap market have been terrible places to be invested. Just look at how investment fund Crystal Amber (CRS:AIM) has seen its share price nearly halve (-48.1%) year-to-date, and Aberforth Split Level Income Trust (ASIT) is down 43.7%.
THE NUMIS SMALLER
Companies index (excluding investment trusts) has delivered annualised returns
of almost twice that of the FTSE All-Share index between 1955 and 2018.
It has also smashed the performance of both long and short-dated government bonds, and massively outstripped UK property prices, according to data compiled by the Financial Times.
WHAT TO DO NOW
‘(The current market level offers) a really interesting buying opportunity,’ says Jonathan Brown, who runs the Invesco Perpetual UK Smaller Companies (IPU) investment trust. ‘There’s been quite a few companies we’ve been waiting for a suitable entry point that are finally looking cheaper now.’
Interestingly, fellow asset manager River & Mercantile last week lifted its ban on new investment into its River & Mercantile UK Smaller Companies Fund (B1DSZR9) after bolting the door to new investors in 2015.
Investing in smaller companies can bring a sense of excitement, particularly as a contract win or technological breakthrough can have a large impact on earnings or company valuation. However, this is a higher risk part of the investment market as setbacks can and do occur.
Investors should only allocate a small part of their portfolio to this space, and perhaps not at all if you cannot stomach large moves up and down in the
share price.
For those happy to proceed, and fully understanding the risks, there are still a few things to note before you consider putting any money into the small cap space at the moment.
Watch for potential supply chain disruption, says Dan Whitestone, who runs the BlackRock Throgmorton Trust (THRG). This could have one of the biggest impacts on smaller companies unable to procure the components they need to keep their businesses running.
Debt is also an issue for smaller companies, says Whitestone, particularly those that may need to refinance existing borrowings.
‘If you’ve got a lot of debt, you’ve got a massive problem because you may not have any earnings, you may not have any revenues, you may not have any other things, you may have a massive fixed cost base,’ Whitestone explains. He adds that smaller companies can become ‘totally exposed, and they may not survive’.
Highly indebted firms might be experiencing a share price rally at the moment, but that doesn’t mean the rally is sustainable. These companies still need to resolve their debt problems which is unlikely to be an easy task.
INVESTMENT IDEAS
Arguably, investors would be better off focusing on higher quality businesses rather than buying whatever small caps are currently rebounding following the market sell-off.
Jeff Harris, co-manager of the Strategic Equity Capital (SEC), says attractive qualities include strong cash flows, repeatable revenues, limited exposure to economic cycles and strong financial positions, citing the examples of Alliance Pharma (APH:AIM), Medica (MGP), XPS Pensions (XPS) and Ergomed (ERGO:AIM).
If you want to get exposure to small caps via funds, we suggest you look at Franklin UK Smaller Companies (B7FFF70) and Tellworth UK Smaller Companies (BDTM8B4), both of which are on AJ Bell’s ‘favourite funds’ list.
Otherwise, we now offer three stock ideas involving attractive businesses with the right qualities to prosper longer-term. There may be a few bumps along the way, but we’re happy to buy at the current price and be patient.
Judges Scientific
(JDG:AIM) £46.40
Judges Scientific has a proven model of expansion, profit growth and value creation from running a portfolio of niche science-based businesses spanning nanotechnology, fibre optic testing, advanced materials, LED design and x-ray technology.
It boasts consistent mid to high single-digit organic growth and impressive 21% operating margins with scope to expand. It throws off plenty of cash and its dividend is covered up to five times by earnings.
On 18 March it said the effect on current year trading performance would be limited if the coronavirus outbreak only lasts a further two months, but would have a progressively growing and more significant impact thereafter. However, it did add: ‘It is currently expected that the impact on the group will only be temporary and, that with its robust financial position, the group’s ability to conduct its business model will remain intact.’
DiscoverIE
(DSCV) 495p
This electronics engineer has been doing a cracking job climbing the value chain in structurally growing markets where equipment specifications are high-performance, reliability, efficiency and regulations-driven.
Think medical, aerospace, transport and renewables where it designs and makes blade controls for wind turbines and AI-based telematics and connectivity components.
The company boasts strong cash flow and a balance sheet with over £100m of headroom against its debt facilities.
MJ Gleeson
(GLE) 670p
The housebuilder stands out from others in the sector because of its focus on the ‘affordable’ end of the market, where demand is most intense for new homes. Its starter two, three and four bedroom homes start at £90,000.
Gleeson recently raised £16.4m by issuing new shares for cash which puts it in a stronger position to get through the coronavirus crisis and get back to work as soon as possible.
‘Gleeson’s customers should be the least likely to cancel and the fastest to return,’ says investment bank Liberum. ‘84% of customers are first-time buyers and 60% key and
essential workers.
‘The group has excellent liquidity, and can now withstand 23 months of zero revenues.’
DISCLAIMER: Editor Daniel Coatsworth has a personal investment in Tellworth UK Smaller Companies referenced in this article.
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