Smaller companies by their nature receive considerably less scrutiny from analysts, brokerages and investors than those making up the Dow Jones Industrial or FTSE 100.
That is a double-edged sword of course, but while there could be more landmines than among household name companies, it also means there will be more bargains to be discovered.
Independent of the returns delivered, small caps always have an aspect to their appeal for both active managers and investors in active funds that bigger company stocks cannot match.
From the manager’s perspective they can really prove their stocking picking skill in a way that large cap managers whose funds look a lot like the index find hard to. From the client point of view, they can feel more assured that managers are putting in the hard yards and getting hands on with companies to earn their fees.
This effect is only all the greater when equities markets are a long way into a bull run, as is the situation now.
Axa Wealth’s Adrian Lowcock is one believer in the virtues of small caps and sees valuations as increasingly attractive.
“With stock markets hitting new or multi-year highs finding investment opportunities at cheap valuations has become more difficult,” he said. “Whilst the UK market is not cheap, smaller companies are one of the more attractive areas where relative value exists.”
“Investing in smaller companies requires more than just buying at low P/E multiples,” Lowcock cautioned. “Talented managers are able to identify companies which are growing rapidly and have strong earnings growth which may justify a much higher valuation.”
Lowcock said at this stage small caps can be considered a contrarian play given the lukewarm demand from investors.
“Investors have been avoiding the sector with £189m being taken out in the first three months of the 2015” he said. “Multi-cap asset managers had until recently been switching out of mid-sized and smaller companies.”
According to Cavendish Asset Management fund manager Paul Mumford, the key to taking advantage of small caps is to target the right sectors.
“If you look at the oil and gas sector I prefer the smaller companies to the likes of Shell. There is a bigger risk to be aware of but if you spread your investments among multiple companies there is outstanding value to be had,” Mumford said.
“The pharmaceutical sector is another one. I prefer smaller companies here which don’t have these huge R&D budgets the likes of Glaxo have and don’t have to keep replacing drugs which come out of patent,” he said.
In contrast, Mumford said the mining sector is an exception in that investors would be wiser to stick to the big names like Rio Tinto because they are better able to withstand the lower global prices of recent times.
Mumford also noted the increased likelihood within smalls caps of snapping up a company that subsequently gets taken over at a substantial premium, something which can lift an entire fund.
