The buoyant start to 2013 has seen the demand for UK smaller companies continue as investors’ appetite for risk has increased in-line with growing confidence in the global economic outlook. Co-portfolio managers on the Franklin UK Smaller Companies Fund, Paul Spencer and Richard Bullas believe that small caps can continue to make headway and outperform the broader market as investors search for growth companies in an otherwise low or no growth macro environment.
We believe valuations continue to look attractive. The Franklin UK Smaller Companies Fund benchmark index, the Numis Smaller Companies Index, is currently trading at a discount to the FTSE 250 Mid Cap Index. Both indices are on a slight premium to the FSTE 100, however if you strip out the volatile resources and financials sectors the FTSE100 is also on a slight premium to smaller companies. Earnings growth is also forecast to be higher for UK Small caps with current projections forecasting around 7% growth compared with just 5% for the larger blue chips. Earnings expectations seem to have reached a realistic level after a period downgrades during the second half of 2012 and this valuation discount seems excessive and has the prospect to narrow over the next 12 months.
On investing in UK smaller companies Paul Spencer said: “One of the genuine opportunities is the large investable universe, giving us the ability to invest in a variety of sectors and companies with exposure to attractive end markets that are relatively independent of the prevailing macro conditions. One such sector is Technology, one of the fund’s largest overweight sectors. There are strong structural growth themes within the Technology sector which are likely to continue in the near term as companies invest to maintain a competitive advantage, increase efficiencies and grow their underlying businesses.
“For example, the emergence of the “Mobile Internet” and the proliferation of high capability mobile enabled devices, including smart phones and tablets, and the growing need for wireless connectivity, are key trends driving and sustaining the expected growth rates for companies that are associated to these drivers.”
Commenting on international exposure, Richard Bullas stated: “There is a national bias towards UK earnings within the UK small cap sector but the full opportunity to gain exposure to overseas-based earnings is often misunderstood. In fact, estimates suggest that approximately 47% of revenues in the Numis Smaller Companies index are generated overseas, with the remaining 53% generated in the UK. This provides the opportunity to construct a portfolio that can gain from faster growing economies and markets. There are many UK businesses that have successfully expanded overseas as they look to gain exposure to both higher growth markets and new territories.
“Many of our core holdings have exposure to overseas earnings including emerging markets. For example, Avon Rubber PLC, a small cap engineering group specialising in the Respiratory, Defence and Dairy markets, produces world leading protection masks and filters for the US military, homeland security and the emergency services. Their dairy division supplies consumable liners and tubing used in automated milk production and generates approximately 85% of its revenues for the US with its rest of world revenues growing strong. The company looks set to enjoy a period of strong growth through geographical expansion and successfully launching new products, showing the benefits after a number of years of investing in R&D.”