London Shares in smaller UK companies have rebounded faster than FTSE 100 stocks this year, as global investors switch their holdings to profit from a more stable economic environment. But portfolio managers warn that this small-cap rally can only be sustained by further evidence of improving conditions.
In the first quarter, many smaller company share prices made up their losses from 2011, in a turnaround that outpaced the performance of so-called blue-chips. Having fallen 12.5 per cent last year, the FTSE Small Cap index was up 14.7 per cent in the three months to March 31. By contrast, the FTSE 100 index fell 2.2 per cent in 2011, but has gained only 4.6 per cent in this year's recovery.
A rapid shift in risk appetite can explain the price movements, according to Jane Sydenham, investment director at Rathbone Investment Management. "Last year was an extremely challenging and volatile one for investors, and risk aversion dominated," she says.
"The closing months saw a move towards large-cap equities, as the problems in Europe underlined the risk to sovereign debt versus the attractions of lowly-rated cash generating multinational companies. In the New Year, as the implications of the European longer-term refinancing operation became clearer, the position reversed itself completely."
Helping banks to refin-ance is of greater benefit to smaller companies — and can only increase investor confidence in them, argues Sheridan Admans, investment research manager at broker The Share Centre.
"It is important for smaller and mid-sized companies, as constraints on liquidity affect them more than large FTSE 100 companies, where credit is more readily available," he says. "This has led to investors taking on more risk in the last quarter."
Adrian Lowcock, senior investment adviser at broker Bestinvest, believes small-caps have simply demonstrated their closer correlation to economic forecasts. "The sector tends to underperform when the economic outlook is weak and rallies as investor confidence grows," he notes.
Even so, the extent of the rally is likely to have caught some discretionary portfolio managers by surprise, according to Dean Turner, investment strategist at HSBC Private Bank: "The recovery has tended to favour the more cyclical, higher beta areas of the market," he says. However, Sydenham has seen evidence that investors around the world have tried to catch the bounce.
"Investors have switched to so-called ‘risk-on': moving from high-quality defensive stocks to more cyclical and smaller companies, reflecting the perceived value in high-beta stocks," she says. "This theme has not only played out in the UK, but in a number of markets including Germany via the Dax, and in the US via Nasdaq."
US investment manager Brown Advisory reports a 29 per cent rise in the price of its US Smaller Companies fund in the past six months, and "a substantial pick-up in interest in small-cap stocks among institutional investors".
In Europe, Baring Asset Management says a return of confidence in the Eurozone, together with an increase in takeover activity, should create a similarly "favourable environment for small and mid-cap stocks to perform".
Mike Savage, a partner at broker Killik & Co, has already seen his favoured small-cap oil and gas stocks — Cove Energy and Wessex Exploration — benefit from increased risk appetite and takeover bids. His tech stock picks - Bango, Toumaz and Imagination — have also followed Nasdaq's lead.
But most agree that, for UK small-cap outperformance to continue, economic indicators will have to remain positive.
"This rising level of risk appetite is a classic phen-omenon at market inflection points," says Sydenham. "Its sustainability will depend on real follow-through in terms of the improving economic statistics that we have seen in the US. Any series of deteriorating economic statistics is likely to send risk appetite back the other way."
Turner suspects the momentum behind small-caps cannot last much longer.
"The outperformance of small and mid-caps will be harder to sustain in the near term," he warns.
"In our view, growth is likely to be lacklustre in the UK for some quarters yet which should favour the large-cap stocks which have a higher exposure to the faster growing emerging market economies."
He adds that recent price rises have taken small-cap valuations back to their historic averages relative to large-caps.
For this reason, Tom Becket, chief investment officer at PSigma Asset Management, continues to favour larger companies — and attributes their underperformance to short selling by hedge fund managers.
"If investors and pension funds start to warm to the concept of owning equities, we believe that they will err towards the larger, better-known companies, which could help to reverse the recent performance differential between small- and large-cap shares," he says.