Foreign exposure helps small caps weather storm

UK smaller companies will lag blue-chip peers in 2010, hamstrung by an ailing domestic economy and a weak pound, but those firms with larger foreign earnings, including miners and recruiters, are good bets to outperform.

Smaller businesses are more exposed than their large cap peers to the recovery in the UK economy, which will be stifled in the short term by uncertainty over an upcoming election, and in the longer term by a huge fiscal deficit.

According to analysis by Reuters of the companies that break out the data, FTSE small and mid cap firms rely on revenues generated outside of the UK for around 35 percent of turnover, compared to 60 percent in the FTSE 100.

Those businesses with profits linked to operations in the United States will benefit from an already weak sterling, which is likely to fare badly against the dollar as UK interest rates are set to stay lower for longer as the UK recovery lags its rivals.

"Overseas earnings exposure will be a benefit because as you can see from the way the markets are behaving at the moment, there isn't much momentum behind UK Plc" said Richard Power, manager of Octopus Investment's UK Smaller Companies fund.

The pound hit a 10-month low against the dollar of $1.4781, earlier in March, partly on jitters the election expected in May will produce a hung parliament unable to tackle the deficit.

The weak currency will give British firms which have a high proportion of their earnings in the dollar a boost as well as making UK assets attractive to foreign investors.

Britain's largest coal mining company UK Coal is one potential beneficiary from sterling's weakness. 

"The fall in sterling from its recent level is good news for UK Coal" said Charles Kernot analyst at Evolution Securities. "Effectively 95 percent of its revenues are U.S. dollar linked as it sells its output in U.S. dollars."

Other companies picked out for their U.S. earnings exposure include defence outfit Chemring, network monitoring company Endace and electronic components distributor Premier Farnell.

Chemring is a UK defence contractor, whose counter-measure products help fighter planes avoid missile attacks.

Although the defence sector could be subject to cuts after the election, Harry Nimmo, manager of Standard Life's UK smaller companies fund, said the firm's "premier position on the Department of Defense in the U.S." and its "extraordinarily shrewd" acquisitions, should help it see off any UK headwinds.

The global financial crisis condemned the British economy to six straight quarters of decay until the last three months of 2009, later than its U.S. and euro zone peers, when it posted growth of 0.3 percent.

UK quarterly growth is expected to grind towards 0.6 percent in the second half of 2010, compared to the world's biggest economy, which is predicted to grow by 2.9 percent in 2010 on an annual basis, according to economists polled by Reuters.

EMERGING TREND

U.S. dollar strength will also benefit those businesses with earnings linked to the emerging markets, many of whose currencies are pegged to the U.S. dollar.

Nimmo at Standard Life said his fund had formed an emerging market theme in recent months as the UK economy has lagged the growth in emerging countries. 

"These (emerging) markets have been resilient. We have seen the opposite to the destocking in 2008, with most manufacturers now convinced we are in recovery phase and seeing the need to re-stock aggressively" Nimmo said.

He picked out precision engineer Renishaw, which has around 20 percent exposure to East Asian activities, saying it could see a significant upward movement in its earnings forecasts and its share price in the short term.

Power was bullish on Michael Page, which he says has built a global operation after initially acquiring a presence in the U.S.

Michael Page has around 60 percent exposure to markets outside the UK and Ireland and trades on a price earnings ratio of around 37 times, compared to Robert Walters, which has the same non-UK exposure and trades on a PER of 50 times, according to Thomson Reuters data.