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Mid-caps remain a safe haven but value remains in the small-cap universe, according to UBS
With small cap stocks continuing to struggle as a result of the relatively high cost of raw materials, the rising cost of labour, and currency inflation, mid-cap stocks and larger small-caps are providing safer havens for investors. But, if you know where to look upside can still be found in the small-cap universe, said David LEPPER, Head of Regional Small Caps Research, speaking at the UBS Little Acorns Conference.
In the face of rising resource costs and stronger Asian currencies, small-caps in the region posted lower-than-expected earnings in August. As a result, UBS's earnings estimates for financial years 2006 and 2007 have been pared back across the small-cap sector throughout the region.
Nevertheless, liquidity among small caps remains high. Small-cap trading volumes have been consistently trending upwards over the last six years, with hedge fund activity a major contributing factor particularly in the last 18 to 24 months. And while the last quarter has seen some decrease, volumes remain broadly in line with 2005 levels.
"Part of this increase in activity can also, to some degree, be linked to foreign fund flows, which have increased steadily over the last three years. With foreign buying renewed over the last few months, we would expect activity in the smallcap segment to rise commensurately as we move into the fourth quarter.
"At the same time, the management of smaller companies can be expected to undergo a period of transformation as the second generation of core shareholders and external management move into managerial positions. We expect an emerging generational shift to bring about a different style and a fresh approach to business and strategy" added Lepper.
A redefinition of strategic direction has the potential to trigger significant change, believes Lepper. "First, we could see family stakes being sold down in some companies, as the old generation extracts capital while the new generation relinquishes some control in return for increased minority ownership, free float and liquidity. We would like also to think that some of this could come from a realization that to maintain board control a shareholding level of 60-70% is not required.
"At the same time, we also expect to see an emergence of outside management. The second generation, which in many cases has received the benefit of overseas education as well as outside working experience, is likely to have a wider pool of contacts upon which to draw. Ultimately, we believe that the small cap sector will benefit from having a more diverse pool of expertise and experience at the helm.
"Generational change is also likely to prompt a re-examination of financing structures, which could see a greater focus on capital management, and hence use of debt," he added.
Any change in shareholding structures has the potential to lead to M&A activity especially as balance sheets remain healthy and are, if anything, under-geared, according to Lepper.
"Borrowing costs are manageable and valuations are attractive in certain segments. Furthermore, we would expect the second generation of shareholders to be more amenable to undertaking M&A.
"Private equity activity in the small cap space in Asia can also be expected to increase. To date, this has been concentrated on the unlisted sector. However as in other developed markets such as the US, Europe and Australia, the closing of valuation differentials will bring about an increase in the listed space.
Overall, we believe that generational change provides a good opportunity for companies to re-focus on improving corporate governance, increase reporting disclosure (timeliness, format and quantity) and investor relations in general; all of which should benefit the small cap space," he said.
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