UK small companies set to outperform for fifth year

Investors in smaller British companies will prosper again this year as takeovers and a quest to find bargains see those shares outperform blue chips for the fifth year in a row, market experts predict.

The FTSE Small Cap Index of companies worth under £500 million climbed 19 per cent last year, beating the FTSE 100 index's 11 per cent gain.

And market experts see this trend continuing this year.

"We have got economic growth during the year and I think we will see continued takeover activity in small and mid caps," Frank Manduca, fund manager at UBS Asset Management, said.

On top of that, a lot of small companies are undervalued.

"The further you go down the pecking order, the more value there is," Charles Stanley analyst Robert Corden said.

"Below a market capitalisation of £50 million, there is some exceeding good value in companies, and we are talking about the ones that are profitable," Mr Corden added.

Scottish Widows' fund manager Christopher Bamberry advises investors to look for firms with strong cash flow and balance sheets. "They could either do bolt-on acquisitions that enhance earnings or they buy back shares or enhance dividends."

For all three experts, small cap software firms represent a promising bet this year. "A lot of software companies are looking relatively cheap compared to some other sectors," Mr Manduca said.

Mr Bamberry, however, thinks the aerospace, electronics and business publishing sectors are most ripe for consolidation.

For Mr Corden, the healthcare sector is a likely area for M&A activity.

"There are more and more big health companies that are saying 'Hang on a second, there is a nice little £200 million acquisition I can make' and that can be 100 per cent more than the market cap before the bid," he said.

But Mr Corden, who is convinced healthcare firms deliver good growth rates, cautioned that the US dollar could be a fly in the ointment.

"For health companies the US market is so important and if you have got a cost base in sterling and you are selling into dollars, which is not worth as much as last year, it will have a big effect on your earnings," he said.

Mr Corden expects the pound/dollar exchange rate to go over two dollars to the pound this year - for him the main drag on company earnings.

Mr Bamberry agrees, but with the economic background in Britain quite stable, he reckons earnings growth will still be a healthy double digits.

Brewin Dolphin chief strategist Mike Lenhoff is certain that small caps will again prosper if the economy does well. He showed in a study that in the past 30 years small caps tended to outperform whenever the business cycle was on the upswing.

"If you are of a cheerful or optimistic disposition and reckon that the outlook for economic growth, corporate profitability and the equity markets is still okay, the message is to remain positive on the outlook for the mid and small companies," he said in a note.