Smaller companies funds lead the way in UK growth sector

UK growth funds investing in smaller companies outdistanced their mainstream counterparts in performance terms during the fourth quarter of 2006, according to Standard & Poor’s Fund Services’ latest update on the sector, available at funds-sp.com.

The median smaller companies UK growth fund returned 12.6% over the quarter, against 11.9% from the FTSE SmallCap index, with a return of 27.7% over the full year against 22.9% from the FTSE Small Cap index. By comparison, the median mainstream fund returned 6.7% over the quarter, outpacing the FTSE All Share index 6.3%. It showed a gain for the year of 16.3%, below the 17.6% return from the FTSE All Share index.

“Funds that outperformed in the smaller companies sector were those with a high weighting to the strongly performing mid-caps and a low weighting to the laggard AIM market”, said S& P fund analyst Alison Cratchley, adding that stock selection was also important, as always in the small-cap sector. She cited the example of the top performer in the sector, over both three and 12 months, the S& P AA-rated Standard Life UK Smaller Companies Fund, which currently has around 43% of assets in mid-caps against 20% in AIM-listed stocks. However manager Harry Nimmo sees rigorous stock selection as the key to success. Notable contributors to performance in the fourth quarter included most of the fund’s largest and often long-held positions, such as Datamonitor, Aveva, Chbloride, Big Yellow, Kier, Raymarine, Restaurant Group and Chemring.

At the other end of the scale, First State British Smaller Companies Fund recorded bottom quartile returns, suffering from its high exposure to AIM stocks. Manager Paul Jourdan has sought to reposition the portfolio to focus on more liquid, larger stocks, but redemptions (the most recent in September) have slowed his progress.

“Among the mainstream funds, sector allocation, capitalization bias and stock selection all contributed to success,” said S& P’s Cratchley. An example was the S& P AAA-rated Rensburg UK Select Growth Trust, which continued to rank in the top quartile of the UK growth mainstream sector. There were two reasons for the fund’s strong showing in the fourth quarter. First, it gained from its underweight position in the poorly performing pharmaceuticals and oil sectors. Secondly, it benefited from a high exposure to the small-cap segment of the market, which staged a year-end rally. Individual winners included property fund and asset management company Teesland that performed strongly following a bid approach and consultancy group Scott Wilson, which rose on the back of an earnings enhancing acquistion.

Down in the bottom quartile, the AA-rated Martin Currie UK Growth Fund had several explanations for its poor performance, including a couple of stock disappointments, notably British Energy (which knocked 80bps from performance) and Astra Zeneca (50bps). Another blow was that the fund did not benefit from the M& A activity surrounding the FTSE 250 because of its current focus on FTSE 100 companies (more than 90% of assets). Finally, the fund has its main sector overweights in oil & gas and mining and was therefore hurt by the fourth quarter fall in oil and commodity prices.

As far as the outlook for the UK equity market is concerned, most managers interviewed by Standard & Poor’s were generally positive on the fundamentals. William van Straubenzee of the S& P A-rated JOHIM UK Fund was one of many pointing to low valuations, strong dividend growth and the strength of corporate balance sheets. He said the market was further supported by ongoing share buybacks and potential M& A activity.