Value is proving elusive in small caps

A leading City fund manager has confessed that value is getting harder to come by at the quality end of the universe of smaller companies and that, despite recent strong performance at the more speculative end of the market, a period of consolidation is underway.

"At the headline PE level small caps appear to be standing at quite a large premium to large caps," said Catherine Stanley, manager of the F&C UK Smaller Companies Fund, "though you need to bear in mind when making such comparisons that the sector composition is wildly different and also that earnings growth forecasts for small caps, according to Blue Oar Securities, are over 12.6% for the next twelve months compared to 10.2% for mid caps and just 5.2% for the FTSE 100."

"However, the issue we are finding is more at the stock specific level rather than the headline level. Among the more mainstream, well established smaller companies which are ideally suited as core holdings, value is proving elusive. We are therefore looking further afield for opportunities, with the strongest performers in the market being special situations and recovery type plays as well IPOs," she explained.

Stanley points to the example in her fund of digital TV technology group Pace, which had been a poor performer with serial disappointments, but has turned around this year and is now trading well. She also highlights the successful IPO of the Individual Restaurant Company, a small restaurant group which reversed into Bank Restaurants at the end of last year to form a larger group and is now rolling out the Piccolino Italian restaurant concept.

Stanley notes that the FTSE Small Cap Index, a key benchmark for smaller companies listed on the main London Stock Exchange, has underperformed both mid and large caps year-to-date while the more speculative FTSE Fledgling Index and the Alternative Investment Market, a laggard during 2006, have both done much better with the FTSE AIM Index up some 16% so far.

"In our view some of the under performance in small caps has undoubtedly been driven by the anticipation of interest rate rises which tends to hurt small cap sentiment, though the worst of this has probably passed. Some of the action at the higher risk end of the market could be short-lived in which case the generally tougher climate for small caps may continue in the short term."

"That said, we are not seeing an increase in profit warnings from quality small caps and the fundamentals driving these businesses remain in place. Many investors feel a general equity market correction is on the cards, however with smaller companies already lagging other parts of the market in terms of performance, we believe they have the potential to recover ahead of the broader market.," she concluded.