UK small and mid caps back in favour

As the UK economic recovery gathers momentum, is now the time for investors to be paying more attention to UK small and medium sized companies?

UK small and medium sized companies have at times outperformed large companies and can be well positioned to capitalise on the UK's recovery. They are not as well-researched as companies in the FTSE 100 (UKX) index so in many cases there will be untapped potential and undiscovered opportunities that some investors have failed to spot.

In the first half of 2013, the FTSE 250 index, which tracks the performance of medium-sized or 'mid-cap' companies, generated a 13% total return compared to 8% in the FTSE 100. The FTSE Small Cap made a 15% total return.

Patrick Connolly, certified financial planner at Chase de Vere says: "Investors must be prepared to accept high levels of volatility when investing in smaller companies, which can suffer large downturns in adverse market conditions as we witnessed in 2008 when UK smaller companies stocks fell by over 40%."

He stresses that the illiquid nature of smaller company stocks pushes prices down too much as investors seek security in more difficult times, but the bounce back can be swift when sentiment recovers as demonstrated by returns of over 50% in 2009 and 30% in 2010.

Connolly says: "It is often the case that small-cap stocks outperform large caps in a rising market but underperform in a falling market. However, mid- and small-cap stocks have already performed well; UK smaller companies is the top-performing investment sector over the past two years, returning 54.2%, with some funds doing considerably better than this."

Founded in 1884, the JPMorgan Asset Management-managed Mercantile Investment Trust is one of the oldest and largest investment trusts taking advantage of this space, although it is more heavily skewed to the mid-cap arena.

The investment trust, which has a current market capitalisation of £1.3 billion, is managed by Martin Hudson, Guy Anderson and Anthony Lynch, and is benchmarked against the FTSE All-Share Index excluding the FTSE 100.

It aims to achieve capital growth, although it also targets an attractive income yield, and the trust sits in the Association of Investment Companies' UK Growth sector.

Lynch explains the advantages of having a high exposure to the FTSE 250. "The FTSE 100 is dominated by the largest companies. So if you invest in the FTSE 100 realistically half of your exposure is going to be up to 10 companies. That can throw up serious risks around the concentration of your income." Lynch points to the example of BP following the Deepwater Horizon disaster in 2010. When it suspended its dividend it was a shock that hit the whole index.

He adds: "We get a much better broad exposure and it is the best way to play the domestic economic recovery. In the FTSE 250 over half of its exposure is to the UK, and we are so confident about this part of the market." The trust currently holds 85 medium-sized companies and 45 smaller companies.

Analysts at Oriel Securities report that despite strong recent performance there is value in the small and mid-cap space, recommending the Mercantile investment trust as one way to take advantage. Iain Scouller, contributing analyst at Oriel, says: "Many trusts in other sectors such as UK equity income, international income and infrastructure that offer higher yields are currently trading on substantial premiums to NAV (net asset value)." Mercantile's share price discount to NAV is currently 12% and the trust is yielding at 2.3%, which makes it attractive.

Over one year, the trust has returned 31.8% compared with 29.9% in the IT UK growth sector as at 9 October. "Over most time periods historically, exposure to small and mid caps have been rewarding for investors; we feel now is actually a really interesting time to be thinking about this market," says Lynch.

He says many company management teams he has met recently - around 250 a year - are providing plenty of evidence of a broad economic recovery across the UK, and that small- and medium-sized companies look set to continue to grow their revenues, earnings and dividends. "There are good opportunities for stockpicking particularly amongst companies with leading market positions and strong balance sheets, which have the ability to invest for growth or to increase distributions to shareholders."

Lynch adds: "The investment trust structure is the best way to play the market; at Mercantile we are able to make long-term investment decisions and these are able to grow at their own pace. We are not forced sellers driven by inflows and outflows and we have long-term capital which is tied up. We can tuck money away in long-term opportunities rather than having to really focus on the next quarter's earnings."

Bullish on UK housebuilders

Six out of the top 10 holdings for the investment trust are UK housebuilders, a major theme in the trust, and the largest overweight sector is consumer goods.

Top holdings in the trust include; Persimmon, Bovis Homes, Jardine Lloyd Thompson, Cable and Wireless, Mondi, Barratt Developments, Taylor Wimpey, Berkeley, Bellway and Hiscox.

Mercantile's Hudson says housebuilders are beating expectations, particularly with the recent government stimulus supporting the sector.

Peter Webb, founder of Webb Capital, agrees housebuilders are an easy call given the government incentives to boost this market via cheap finance and looser planning regulations.

However, while he believes housebuilders will continue to run with the positive news flow, Webb warns: "Investors should not forget just how cyclical housebuilding is and I would be cautious of paying more than net asset value for a housebuilder in anything other than the early stages of economic recovery."

He adds: "Without doubt there are many attractive investment opportunities emerging from within the small and medium-sized company universe as the economy gradually recovers from a low level of activity."

Identifying the golden investment opportunities in the small and mid-cap space

Chase de Vere's Connolly warns there is a danger that much of the easy money has already been made in small and mid-cap shares so investors should stick with "proven managers" and hold these alongside larger-cap stocks, where there might currently be better value, and to provide diversification.

Webb says: "It will be crucial that investors focus on companies with strong management, good gross margins and financial strength to make the most of the improvement in profitability and valuation that will occur as the economic recovery gathers momentum."

He adds that he is convinced that this sector of the market will continue to deliver superior performance over the longer term. "After all, smaller companies are more nimble and responsive to market opportunity than their larger brethren and the potential for growth in profitability greater. A good part of the overall outperformance of small versus big is due to superior dividend growth amongst the minnows. It is quite likely that we are entering such a phase in markets right now where smaller companies once again show larger companies a clean pair of heels when it comes to dividend growth."