IPOs breathe life into stagnant small caps after investment struggle

Investments in the UK’s smaller companies have struggled this year, but some fund managers are hoping that newly-listed companies will help revive the sector.

 

Since the start of the year, small caps quoted on the FTSE Aim All-Share TR index have lagged their large-cap peers on the FTSE 100. But since April, smaller companies have picked up speed, and have risen to a 7.6 per cent return – not far behind the 7.9 per cent performance of the FTSE 100.

 

Election jitters have likely played a part in deterring international investors from the FTSE 100, but there are fundamental reasons why smaller companies could outperform their larger peers this year.

 

Smaller companies had been enjoying a brilliant few years of performance, but in 2014 things began to change when a number of the sector’s best-loved companies stumbled. Clothing company Asos, for example, was hit by a fire at its main warehouse and subsequently issued a series of profit warnings. 

 

Insurer Quindell was hoping to move up to the FTSE 100 when its share price hit 640p last year. But since then, a furore over its accounting practices and the loss of its chairman over his share dealings meant Quindell’s stock price fell as low as 25p. 

 

In the meantime, the sector has been hindered by interest from “tourists”. These are investors, typically from hedge funds, which invest in an area on a “just visiting” basis. 

 

Rather than investing for the long term, they buy up large quantities of shares – fairly indiscriminately – and then sell out after a short period of time when they have made their gains. This kind of speculation is bad news for anyone hoping to invest sensibly.

 

Since the credit crisis, there has been a dearth of initial public offerings (IPOs) in the small cap space. Without new blood refreshing the market, there has been a sense of “sterility” about small caps, says Dan Nickols, manager of the Old Mutual UK Smaller Companies fund.

 

However, recently there has been a spate of smaller company IPOs, and some fund managers believe this will help revive the sector.

 

“One of the pleasing features of the last year or so is that the IPO market has definitively opened up. Whether that will be the case post-election I don’t know… But there has been such a long period of nothing,” says  Nickols.

 

One recently-listed company which has caught his eye is Fever-Tree, which manufactures upmarket tonic water. It may seem strange that a specialist in premium mixer drinks would be a compelling investment, but the products are sold in more than 40 countries, and long spirit drinks are growing in popularity. 

 

“Fever-Tree has exceptionally low market share of 1 per cent in the UK,” Nickols admits. However, he says this shows there is “latent potential” for growth, compared to larger companies which are now finding it difficult to expand their customer base. 

 

“It is big enough to project itself on to a range of markets… In spite of being sold in Waitrose for nine years, Fever-Tree still grew their sales with them by 40 per cent in 2014, which I think is impressive.”

 

Another recent IPO which has been highly rated by fund managers is support services company Lakehouse, which specialises in housing. Its chairman, Stuart Black, was previously chief of housing company Mears during its fastest period of growth. 

 

“It struggled to get the IPO to market so they cut the price… But there is the opportunity for them to make bolt-on acquisitions which will have a very good impact,” explains Mark Slater, manager of the Slater Growth fund. “One of the reasons people are worried about Lakehouse is because of the election, but the reality is it is trading perfectly well.”

 

Although new entrants to the market can rejuvenate the sector, both managers are cautious about investing in IPOs and warn there are many “junky” companies out there. 

 

“There is a lot of money chasing after yield and there have been distortions in the market as a result,” Slater says. “One is when you get pretty junky companies listing on the stock exchange, but with very high yields, and people pile in to those IPOs. We avoid those.”

 

The average fund in the UK Smaller Companies sector has made 51 per cent over the last three years, but the best fund managers have managed to nearly double this return. The top fund in the sector is the River & Mercantile UK Equity Smaller Companies fund, which has made 108 per cent in three years. The ongoing charge for this fund is 1.65 per cent. This is followed in the rankings by the Fidelity UK Smaller Companies fund, which has returned 88 per cent and has an ongoing charge of 1.71 per cent.