Investment Week – UK Article
29 October 2009
The rally is well established. Small and Midcaps have been at the forefront of this bull market which was ignited by the recent panic slashing of interest rates - sorry I mean concerted monetary easing to head off the 2008/9 world banking crisis. The market response has followed the pattern of the aftermath of Britain’s unceremonious departure from the European Monetary System of 1992 and of the Long Term Capital Management Crisis in 1998. On those occasions, the FTSE 250 midcap index rallied around 85% in the 18 months from the bottom. Using this analogy, we have made about two-thirds of the appreciation.
The crisis, as well as destroying balance sheets in the banking sector, caught many companies in the more cyclical sectors with their trousers down financially. The balance sheet repair process in the UK has been impressively swift, with £54 billion of new equity being raised in 2009 to the end of August. Retailers, real estate companies, house-builders, plant hire companies, engineers, leisure and media have all arrived cap in hand asking to be bailed out, often by existing shareholders in distressed equity fund-raisings. If existing shareholders have been unable to take up their rights, their stakes have been largely wiped out by the deeply discounted nature of many of these share issues. In the past, such value destruction was normally accompanied by chief executives being “swapped out”.
I’m naturally superstitious and set great store by the changing seasons. For me, October and November spell danger for smaller companies. Having been in the industry in 1987, I associate the month of October with massive market corrections. November, being late in the year can bring “buyer fatigue”. The markets having been lapping up share issues all year now, find the corporate Johnny came lately increasingly tiresome with his somewhat opportunistic requests for cash.
It’s nervous times for finance directors. Many December year end companies realise that living in hope of a big contract win before the year end just won’t wash. The nightmare of a “profit warning” is at hand. However the New Year brings new hope, new optimism, new investment ideas and new themes from institutional sales teams. The investment bankers however are still signed off for Christmas and will not have dusted off their prospectuses until the end of the first quarter.
In a nutshell, this is why the end of November is the best time to commit money to the third leg of the bull market. Investors will be more discerning. The easy “recovery” money has been made. The distressed rights issue will be out of fashion. Investors will be starting to focus on the question of “When will this rally end” and “Should I be thinking about sustainability?” The mould breaking, high quality growth companies have been quietly de-rated as investors rush for trash. Their growth is self financing, their balance sheets are robust, their profit margins are prodigious, their profits are predictable and their dividends are mouth watering. Such gems as Abcam, Paddy Power, Rightmove, Hargreaves Lansdown, Chemring, Victrex and Fidessa spring to mind. These are companies that specialise in the bottom left to top right chart.
In the more cyclical sectors, I would favour those operators that have managed to steer their firms through the crisis without resorting to the highly dilutive distressed share issue. Take real estate for instance, my favoured picks would be seasoned operators like Shaftesbury Derwent London, Big Yellow and Hansteen, all of whom anticipated the downturn correctly and didn’t bet the farm with debt.
Investors have not missed the smaller company rally completely. There is still time to get involved in the third leg. However quality, sustainability and organic growth should be the focus in preparation for the next market phase in the second half of 2010 when visibility is less clear. Solving the banking crisis is like buying a sofa; borrow now but pay in two years time.
Bull
- Two-thirds of the way through the small-cap rally, third leg still to come
- Time to move towards quality, growth & momentum
Bear
- Easy money has been made already
- More challenging market conditions in the 2nd half of 2010
Harry Nimmo, Manager of the Award Winning UK Smaller Companies Fund, Standard Life Investments
This article was first published in Investment Week on Monday 9th November 2009.
