James Phillipps asks whether small-cap fund managers are ready to go bargain hunting

The smaller companies market has certainly been no place for the faint-hearted over the past year but there is a growing consensus that the savage falls it has experienced are throwing up opportunities for the long-term investor.

The sector has been among the hardest hit by the credit crunch, as investors have fled higher-risk asset classes for the safety of cash and government bonds. Share prices have been pummelled across the board in the fallout, leaving a large number of investors nursing heavy losses.

The numbers make for uncomfortable reading. The Alternative Investment Market(AIM) has been the UK’s worst-performing market since the start of the year, down a staggering 42.23 per cent in the period to 2 October. The FTSE Small Cap and FTSE Fledgling indices have fared a little better but have still seen 38.14 per cent and 33.02 per cent, respectively, wiped off their value.

 

Market reappraisal

The question facing those investors who follow the mantra that it is always darkest before dawn is whether prices have now fallen so far that they are starting to look very attractive. Many of the country’s leading small-cap fund managers certainly believe they have. David Crawford, co-manager of the CF Octopus Opportunities Fund, has reduced his cash weighting from 30 per cent to ten per cent. Over at Gartmore, Gervais Williams, who runs the group’s Growth Opportunities investment trust, has also been putting money back into the market, bringing the portfolio’s cash balance down from 18 per cent to six per cent over the last six weeks.

‘It has been a very tough year for everything, but the bottom end of the market has been hit worst,’ Williams says. ‘The universe now looks cheap and there are a lot of stocks very cheap relative to it. This pattern happens very rarely.’

Smaller companies tend to perform significantly worse than their blue-chip counterparts during market downturns, as investors turn their back on them and look to more defensive and liquid assets. Sectors such as tobacco, utilities and large pharmaceuticals come into favour because they are less sensitive to the economic climate. This has again proven to be the case, but is little comfort to small-cap managers who are unable to buy these companies due to their size.


Beyond their control

However, Paul Mumford, manager of the Cavendish Opportunities Fund, says one of the factors that differentiates the current cycle from previous ones has been the level of forced selling in the market.

He explains that many hedge funds had taken big bets on commodity prices continuing to go up, piling into oil and gas, and mining shares, while betting against, or short-selling, financial stocks. When commodity prices started to tumble over the summer, as the deepening banking crisis led to growing concerns about the economic outlook, this bet started to unravel spectacularly.

‘The influence of hedge funds has been significant. A number of them had moved down to the smaller area of the market to buy commodity stocks. As prices started to move the wrong way and redemption pressures started to build, they had to sell them into a market that was not receptive to them and it has had a disproportionate effect on share prices,’ Mumford says.

He adds, ‘This was particularly pronounced in September, which was a pretty gruesome month. Many hedge funds only deal quarterly and as more managers received redemption notices they were forced to sell more stocks. AIM fell by 22.5 per cent, much further than other indices because it is heavily weighted to oil and gas, and mining companies.’

Around a third of AIM’s value is tied to the fortunes of stocks in these sectors. This had served it well in the first quarter as commodity prices soared, but the reversal of this trend has been extremely painful. Even companies in unrelated sectors that have continued performing throughout the downturn have seen their share prices hammered.


The smallest suffer most

Crawford says micro-caps listed on AIM and PLUS Markets have been among the worst hit. Outside of the world of hedge funds, many open-ended funds investing at the very smallest end of the market have also been forced to sell stocks in order to meet redemptions.

In many cases, managers have had no choice but to sell those companies that they can, rather than those that they want to, because of the lack of buyers. This has resulted in the wheat being dragged down with the chaff, prompting a lot of investment professionals to say valuations now look very attractive by historical standards.

‘The sell-off has been broad-based and pretty indiscriminate,’ Crawford says. ‘We think the market has overreacted on the downside and there will be a fantastic buying opportunity and the possibility to make really exciting returns on a two-to-three-year view.’

Few managers are willing to call the bottom of the market just yet, however. In the wake of any sharp stock market correction, sentiment is at its weakest and recovery is dependent on investors starting to buy equities again.

The banking crisis continues to sap confidence and no-one can say with any certainty whether the US government’s $700 billion bail-out package, or its smaller UK counterpart, really marks the end of the credit crunch. Add the fact that the world is entering a phase of slowing economic growth and it is understandable why caution remains the watchword.

Things will get better

However, one thing the rescue plans do underline is the seriousness with which policymakers around the world are treating the current situation and their willingness to tackle it head on. This is where Gervais Williams expects the seeds of recovery to be sown.

‘Interest rates will be cut aggressively as the next step in the process and hopefully this will start to have an effect on the economy within 12 months. The secondary effect will be that people with cash on deposit will see their returns come down sharply and will start looking at alternative places to invest,’ he says.

Neil Hermon, manager of the Henderson Smaller Companies Trust, agrees that interest rate cuts will speed up the recovery. He says, ‘Corporate profits will come under pressure in 2009, as both business and consumer spending slows, but the concerted efforts by the authorities mean that next year should be a better one, as we start to look into 2010.’

There are already some positive signs emerging from the small-cap sector. Despite the credit crunch, there have been a number of significant takeovers in the small-cap universe.

Japanese giant Olympus snapped up medical devices specialists Gyrus at a premium of 58 per cent to its share price, Hermon says. In August, Indian firm, Oil and Natural Gas Corporation, acquired AIM-listed Imperial Energy in a £1.4 billion deal that valued it at a 62 per cent premium to its share price when the announcement was made.


Silent takeovers

Williams says, ‘We are seeing what we are calling a “silent takeover boom”, at significant cash premiums, across a range of sectors. This reinforces my view that equities at the bottom end of the market are very, very cheap.’

Paul Mumford expects this to accelerate in 2009, particularly in the oil and gas and mining sectors, where the sharp price falls mean that many stocks are trading at a significant discount to their assets.

He points to Regal Petroleum as a prime example. At the start of October, it was reported that Shell had made an offer for the company, which valued it at £3 a share. At the time, its shares were only trading at 83p, which is indicative of how undervalued many of these companies’ oil reserves are currently.

‘At some stage we will see a considerable amount of takeover activity in the marketplace. A lot of these oil and gas companies are trading on similar valuations to Regal, despite the fact that they are profitable, have well-funded exploration programmes and are potentially sitting on massively transformable reserves,’ Mumford says.

Richard Power, who co-manages the Octopus fund with David Crawford, is also finding opportunities in the resources sectors. The pair have adopted a twin strategy of investing in companies in the hardest hit sectors, where they believe share prices have been oversold, as well as buying into firms that should prosper in a slowing economy.

Interior Services Group (ISG), a construction company, sits firmly in the first camp. Housebuilders have been decimated by a combination of falling house prices and the lack of availability of mortgages.

That said, ISG has diversified its business and now derives a third of its earnings from outside the UK. Power says it has a market cap of £46 million and is sitting on £30 million in the bank with profits predicted to come in at £15 million next June.

‘ISG has 90 per cent visibility over its earnings and it has won the contract to build the velodrome for the 2012 Olympics,’ Power says. ‘It has a nice war chest of cash that will enable it to take advantage when more of its competitors fall into difficulties. Its share price has halved over the last year though because the trouble is getting investors to stop worrying about next week and step back and adjust their time horizons.’


Value in distress

Among those stocks that will benefit from the economic downturn, Power singles out pawnbrokers and corporate insolvency specialists, such as Tenon.

Nick Greenwood, manager of the iimia Investment Trust, expects distressed companies to be a significant theme going forward. He has bought into Strategic Equity Capital, an investment trust managed by SVG Investment Managers. ‘They take significant stakes in distressed smaller companies with a view to turning the business round,’ he explains.

There are several ways to access the potential of smaller companies but experts agree that the majority of people are best served by investing in a specialist investment trust or open-ended mutual fund. These provide exposure to a diversified portfolio of stocks where the manager can use his skill and experience to hopefully avoid the blow-ups.

However, investors do need to look closely at what they are buying, particularly if they have existing holdings in the sector. Some funds invest exclusively in the FTSE Small Cap Index, whereas others hold stocks across AIM, PLUS Markets and FTSE Fledgling Index.

Mick Gilligan, director of fund research at Killik & Co, favours investment trusts and other closed-ended investment companies, because they do not have to sell shares to meet redemptions in difficult times.

He notes that owing to the weak market sentiment, they are also now trading on significant discounts to their net asset value (NAV), the underlying worth of their share holdings. When markets recover, the NAV typically narrows, providing a boost to returns.