Morningstar's "Perspectives" series features investment insights from third-party contributors. Here, Henry Lowson, manager of the AXA Framlington UK Smaller Companies fund, outlines why he believes the stage is set for small caps to flourish.
There has been an uptick in mergers and acquisitions activity this year; however in the first half of 2014 this was dominated by larger companies. There are now signs that M&A is trickling down the market cap spectrum. Balance sheets are strong and management confidence has improved across the board on the back of a brighter economic outlook, particularly in the UK and the US.
In recent weeks there has been bidding activity for a number of publicly quoted companies, including Hyder, the engineering services company, Kentz, the oil services company and Spirit Pubs, which has been approached by Greene King. More is expected and many smaller companies have their own M&A agendas they are pursuing, both on and off the public markets.
Companies are in a Strong Position
Along with having more cash on balance sheets, credit conditions have also eased, with companies having access to credit at more favourable rates and for longer. As such, there is a greater ability to borrow. During the downturn, many companies reduced their debt levels and are now in a position to invest, or return money to shareholders through dividends. This should be positive for company growth plans and potential shareholder returns.
Earnings Growth to Drive Performance
The period of small cap re-ratings over the past three years, driven by loose monetary policy, is largely complete. Earnings downgrades of smaller companies have now stabilised and earnings revisions are now improving. Valuations look attractive both on a historical basis and relative to other asset classes. The improving UK economy presents a number of opportunities and we should see earnings growth drive long term performance of small caps from here.
Under-Researched Sector Presents Opportunities
With the stage set for small caps to flourish, investors will need to identify which companies are well-placed to take advantage of improving conditions. The small cap market remains under-researched by the analyst community, which creates opportunities to identify companies that are yet to be properly valued by the market.
Two themes where we continue to see opportunities are ‘health and safety’ and ‘self-help’. Three such companies with exciting prospects include:
Sprue Aegis (SPRP), a supplier of domestic safety products, moved from ISDX to AIM earlier this year and is benefiting from the theme of health and safety. It is taking advantage of opportunities presented by new legislation in France and Germany on all houses having smoke detectors. The company will also grow market share in the UK trade market, an area where it has been underexposed, with the launch of a new AC powered product later this year.
Porvair (PRV), a specialist filtration and environmental technology group, is also taking advantage of the health and safety theme. Their filters are typically designed into their end markets, such as in the aviation industry, which ensures that there are substantial barriers to entry for competitors and the company can prosper from significant pricing power. The filters are furthermore consumable and therefore Porvair gains from long term recurring earnings streams.
Restore (RST), the document storage management company, has benefited from self-help and a change in management. Since CEO Charles Skinner took the helm in 2009, the company has reduced its gearing, sold off non-core areas of the business and through organic growth and acquisition, consolidated a fragmented market. He has also added other services, such as IT disposal, to the traditional document storage activities and offered these to existing and new customers.
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