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What potential does the Smaller Companies sector hold?

14 March 2013

An article from Neil Hermon, fund manager of Henderson Smaller Companies.

In recent years the smaller companies sector has proved a great investment. 2012 was no exception; the FTSE Small Cap (ex-investment trusts) index returned 36.29 per cent, more than triple the return of the FTSE 100 index. However, it seems that investors still don’t understand the potential that this sector holds.

Where the opportunities lie

Sectors:

Unlike fund managers that focus on large-caps whose index is dominated by a poorly diversified selection of big companies in the oil, gas telecom, banking, pharmaceutical and mining sectors, managers in small-caps have a more diversified selection from which to choose. This is important, as the real opportunities for smaller caps lie in a range of sectors such as industrial, electronics & electrical equipment, software & computer services and support services, which all offer great opportunities for growth.

Stocks:

Mid and small cap investors rely on managers’ stock picking skills, with the aim of identifying companies with a strong business model, sound balance sheets, solid cash flow and have the ability to outperform the market. Last year one of the winners in my portfolio included Anite, a telecoms testing business that greatly benefited from the roll-out of 4G and as a result raised its earnings forecasts several times in the last twelve months.

Mergers and acquisitions:

Further opportunities for smaller companies include capitalising on mergers and acquisitions (M&A) activity. Global M&A reached its highest level in four years in the final quarter of 2012. Large companies have excess cash on their balance sheets and access to historically cheap financing. This is an encouraging environment for smaller companies, which are likely to benefit as larger companies opportunistically seek out small-scale ‘bolt-on’ acquisitions, in an effort to enhance their growth prospects. Many of these larger companies are willing to pay a significant premium to the trading price for suitable acquisitions, offering a potential uplift to investment returns.

Using investment trusts to reap the benefits of smaller companies

Investment trusts boast a number of unique tools which can benefit investors and their fees tend to be lower than Open Ended Investment Companies (OEICs). One of the main benefits is the ability to gear. If done effectively, gearing can significantly increase returns both in terms of growth and income generated from the underlying portfolio. What’s more, gearing in the current environment is ideal as borrowing is very cheap, especially for investment trusts. Banks will tend to offer investment trusts money at very competitive rates, currently around 1.5%, which compares very favorably with small to medium cap equities yielding 2% to 3%. That means returns can be significantly enhanced.

2013 and beyond

We are currently in a good environment for UK smaller companies, not only because these are geared to the global economy, but also during periods of economic stability investors are able to focus their attention on corporate fundamentals, which are extremely attractive.

Following a raft of support measures announced by the European Central Bank in mid-2012, leading economic indicators have signaled a re-acceleration of growth. This growth is moderate versus history, but is positive nonetheless, and is highest among the world’s emerging economies. One of the major benefits of investing in UK small caps is their exposure to the global economy. When we aggregate the underlying revenues generated by the companies in our portfolio approximately 58% comes from areas outside of the UK.

In the last year we have passed the 10-year anniversary of my tenure as fund manager and the consistent returns (outperforming in 8 of the last 9 financial years) give me confidence that on the whole we are getting things right. However, as a fund manager the work is always ahead of you and clearly hurdles still remain – most notably the deleveraging of the financial sector and governments, but on the whole low valuations, strong corporates and our proven stock picking approach leave me feeling optimistic about the years ahead.

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