Smaller companies have had a phenomenal run in recent years. This year, the market has weakened owing to a combination of global factors: fears over the end of quantitative easing, tensions between Russia and Ukraine, slowing growth in China, and deflation risk in Europe. As I write, geopolitical issues in Iraq are causing further problems.
Many commentators have predicted the market is due a correction. In reality it is impossible to foresee the direction of markets but in my view, setbacks present opportunities.
Perhaps it is not surprising we have seen a correction in the share prices of smaller companies, given their performance over the past few years. The FTSE Fledgling Index was up 48.4 per cent in 2013, with the FTSE Small Cap Index up 43.9 per cent. This follows on pretty good returns for 2012 too.
Funds investing in small and medium-sized companies, such as Harry Nimmo's Standard Life UK Smaller Companies Fund, have been affected by the setback. Highly-rated growth stocks, many of which Mr Nimmo favours for their sustainable earnings prospects, have been affected quite severely. Such stocks were affected further by a concerted risk reduction by investors.
I recently caught up with Mr Nimmo and he pointed out that some of the more cyclical, or economically-sensitive, areas of the market, such as housebuilders, had reached multi-year highs. A period of low interest rates has helped lower quality businesses, as it has offered the opportunity to pay down debt, boosting profit margins. However, this doesn't detract from the cyclical nature of these companies and he argues that many investors seem to have forgotten this.
Perhaps this has been reinforced more recently by Mark Carney's latest speech with a view that interest rates may see their first rise this year rather than next. Mr Nimmo's focus is on quality; given that the portfolio is not skewed towards cyclical businesses, perversely, a rate rise, if anything, would act as more of a help.
The earnings expectations for most of the fund's holdings remain intact and many still offer significant dividend growth. However, Mr Nimmo admits a handful of stocks have seen modest earnings forecast downgrades, but have been accompanied by severe share price falls. For example, after a strong run in 2013, Asos has undergone a savage attack since March this year.
It might appear odd that larger stocks such as Asos and Rightmove are held in a smaller company portfolio. The reason is that Mr Nimmo is keen on running his winners. He is happy to sit tight as a company progresses through the indices, from a smaller company right up to the FTSE 100. This allows the fund to fully capture the growth of some of the UK's most successful businesses.
He has been taking profits from his Asos holding for some time and he tells me this is the third time on his watch the share price has fallen by half. He realises now is the time to recycle profits into new ventures, having made 33 times his money on the stock on average.
New names include Poundland, bought on its recent listing on the UK market. Mr Nimmo makes a good point that the starting valuations for many initial public offerings (IPOs) coming to the market are much too high. We have seen significant inflows into the smallest end of the UK market, which happens to be a particularly narrow part of the market. However, valuations in this area are beginning to come down.
Mr Nimmo also runs an investment trust, which has an 80 per cent overlap with the unit trust. Given that the investment trust is much smaller, he can invest more easily in companies less than £200m in size. After a five-year stock market run, Mr Nimmo is more cautious on equities in general and so the trust is currently ungeared. While he is not an outright bear, he believes the next five years are more likely to offer single-digit annual returns, although this is still a very good return and in my view his cautious outlook is realistic.
Harry Nimmo has taken advantage of the setback by topping up holdings where earnings prospects remain strong. I agree that any further falls provide a clear buying opportunity. My main concern is that investors tend to get out too soon when there is a setback, whereas I would consider this a chance to buy or top up my holdings.
Mark Dampier is head of research at Hargreaves Lansdown, the asset manager, financial adviser and stockbroker. For more details about the funds included in this column, visit www.hl.co.ukReuse content