However in the past two months, the UK market has given up many of these gains. In fact, it feels a little like a rerun of 2011, when the eurozone crisis escalated over the summer and sparked a dramatic market sell-off in equity markets around the world. In 2012, added to this is rising concern about the trajectory of China’s economy.
Equities good; small caps better
Uncertainty is never good for risk assets such as equities, and we expect further volatility in the short term. However on a medium and long-term view, there are strong arguments to suggest that equities will outperform other asset classes. On the evidence of the recent results season, we believe small-cap stocks have even more going for them.
The arguments for longer-term investors to look at equities in today’s market are well known. Falling bond yields are making equity yields increasingly attractive on a relative basis. Corporations are also better placed, compared to the consumer and governments, with strong balance sheets, which should support improving dividends, share buybacks and greater merger and acquisition (M&A) activity. De-equitisation is likely to become increasingly common.
There are a number of themes at play in the UK small and mid-cap markets which make them particularly attractive to investors.
M&A is one of these drivers. Acquisitive larger companies that cannot achieve growth organically are opting to buy growth opportunities.
The UK market is particularly likely to benefit from this, due to its transparent and robust governance environment which ensures buyers are treated fairly. Smaller cap indices are likely to benefit disproportionately from recovering equity markets because of heightened M&A activity.
Small-cap valuations are attractive too. As at the middle of May, the FTSE Small Cap index traded on a price-to-earnings ratio of 8.6 compared to 10.6 for mid caps and 9.8 for the FTSE All-Share index. Both small and mid-cap indices have stronger earnings growth forecasts than the FTSE All-Share does, with a broadly similar dividend yield.
So what are business leaders saying? The latest set of company results were largely better than or in line with expectations. In our meetings with management teams, several themes resonated across companies, including increasing dividend yields, a slowdown in incremental cost savings and more secondary fund raisings, much of which is likely to be spent on M&A.
Greater reliance on private sector
Despite caution on the macroeconomic outlook generally companies are comfortable with higher dividends. Telecoms provider KCOM, plastics specialist RPC and distributor Diploma have all increased dividend payments significantly above expectations.
There have also been several secondary fund raisings to finance acquisitions or accelerate investment. These include fund raisings at Dechra Pharmaceuticals, to finance their acquisition of a competitor and Salamander, which plans to accelerate its oil drilling programme. Cap-XX’s fund raising, for example, will lead to greater investment in research and development.
Another trend coming out of the reporting season relates to public sector outsourcing. Few management teams accurately predicted how long it would take to see significant contracts from the outsourcing of UK central and local government activities. However, private sector outsourcing is accelerating and is likely to benefit several small and mid-sized companies over the next 12 months including environmental services and facilities management specialist May Gurney, office supplies specialist Office2Office and telecoms provider KCOM.
In the small-cap space, the focus for investors should be on well-diversified funds and portfolios that have a track record of selecting smaller companies with repeatable business models, sustainable barriers to entry, incentivised management teams and strong balance sheets.
