2009 was an excellent year for small companies – the FTSE Small cap (ex Investment Trusts) returned +58.2% (Total Return) over the year, significantly outperforming the FTSE 100 at +27.9% (Total Return) . This represented the best absolute performance in 16 years. However this strong performance has to be seen in the context of an exceptionally weak 2007 and 2008 performance (-17.9% and -50.4%), where small companies suffered a dramatic de-rating on concerns about economic slowdown and a high degree of risk aversion amongst investors concerned about financial meltdown.
Last year was categorised by a strong recovery by cyclical stocks, particularly those with highly geared balance sheets. However there was little differentiation within this grouping.
The strong performance of smaller companies closed much of the valuation discount to the market, however small companies are still rated more cheaply than large trading at a forward PE of 10.2x (FTSE Small Cap ex-loss makers) compared to 11.1x for the FTSE All-Share. We believe many small companies still look good value and we see scope for smaller company share prices to make continued progress in 2010, albeit at a lower rate than 2009.
We believe that 2010 will contrast strongly from 2009, with greater differentiation by the market on the basis of stock level drivers and key themes. The key trends we believe will be important for 2010 are:
Growth outperforming
We believe that 2010 will see the market start to re-evaluate businesses that are able to produce sustainable above average earnings growth. Over the last 12 months the premium this segment of the market historically enjoyed has largely disappeared. With our expectation of a relatively slow economic recovery in the UK, investors are likely to pay up more for faster growing stocks.
Increase in M&A activity
2009 saw a dearth of M&A activity given economic and financial uncertainty. As stability has returned, we have seen an increase in M&A within the small cap universe. Much of this is driven by trade buyers who see the opportunity to buy quality businesses on relatively low valuations with significantly reduced private equity competition for deals.
Overseas Earnings
Given high levels of consumer and public sector debt in the UK, we expect a slower economic recovery here than in many overseas economies. We therefore expect better performance from companies and sectors with greater overseas exposure such as the Information Technology sector.
Special situations
Lower economic growth in the UK will mean that businesses able to generate growth through internal actions, for example through efficiency drives or selected acquisitions, will be increasingly attractive. We are looking to support well managed businesses that are looking to expand through strategically sensible and earnings enhancing acquisitions.
Dividend
2009 saw capital appreciation rather than dividends providing the majority of equity returns. As we expect more moderate total returns for equity markets over the next 12 months, dividend payments will become a more important component of total return.
Cautious on public sector capex
We expect to see continued pressure on government budgets, particularly capex budgets and therefore have reduced our exposure to businesses that could be impacted by cutbacks. We do however expect some businesses in due course to benefit from increased outsourcing post the election.
Cautious on UK Consumer
In the face of some pretty strong headwinds, 2009 saw the UK consumer display surprising resilience. 2010 could prove a more challenging year for the consumer with tax rises, unemployment remaining relatively high, and public sector cutbacks and as news coverage starts to focus on the potential for interest rates increases.
In summary we believe small companies can continue to make progress in 2010, helped by increasing M&A activity. We expect a much more disparate performance by stocks within the small company sector. Aviva is committed to the small company sector and we doubled our small company exposure in our Balanced Equity portfolios at the start of 2009. Our portfolios remain overweight in the small companies sector, both as we expect continued relative out performance and as the sector acts as a useful diversifier within our portfolios.
Robin West and Toby Belsom manage over £400m invested in smaller companies. In addition to internal life fund assets, they co-manage the Aviva Investors UK Smaller Companies OIEC which is ranked 16th percentile over 1 year and 31st percentile over 3 years (to 31 January 2010).
For more information on the Aviva Investors UK Smaller Companies OIEC or other Aviva funds please contact the Aviva Investors UK Onshore fund team on 0800 015 4773 or email fund&salessupport@avivainvestors.com
