Smaller UK firms provide investors premium returns

London: Britain's economy is flat-lining, at a time when output in Germany is soaring and China and India are still booming. But if you'd invested a year ago, UK smaller companies would have been the best bet.

There are 55 UK smaller companies funds investors can choose from, and on average they made returns of 30 per cent last year, or about 10 times the top-paying cash Individual Savings Account (ISA). Even if you'd picked the worst single fund, it still made a gain of 11.6 per cent over the year, while the best, from Cazenove, made 53.8 per cent.

Funds invested in global emerging markets, China and the Asia-Pacific all trailed behind UK smaller companies.

Engineering groups and industrial conglomerates are driving the ‘small cap' revival in Britain. Take, for example, Morgan Crucible, an advanced materials group whose products are vital for the aerospace, train and power generation industries.

Its share price leapt from 189 pence last August to 312 pence earlier this month, a gain of 65 per cent. Its latest half-year results revealed that underlying operating profits were up 66 per cent, helped by booming sales in emerging markets.

Morgan Crucible is one of the stocks held by Fidelity's UK Opportunities fund, managed by Alex Wright. "When you look at the remaining engineering groups left in the UK, they have transformed themselves into high quality companies that are enjoying strong demand from emerging markets," he says.

Industrial groups gain

Another of Wright's stocks, Hansen Transmissions, a wind turbine gearbox company spun out of Invensys, saw its share price rise by 96 per cent last week when a German company announced a £450 million (Dh2.70 billion) takeover bid. Although it was loss-making in 2010, Hansen is winning orders from Chinese and Indian customers due to its unique large turbine capability.

But before we get too misty-eyed about a revival in British engineering and manufacturing, the truth is that most stock market-quoted industrial groups left in Britain have relocated much of their manufacturing base overseas.

Hansen is quoted on the London Stock Exchange, but its main manufacturing bases are in Belgium and China, while Morgan Crucible engineered materials business has a "strategically located low-cost manufacturing base, with sites in Mexico, China, Hungary and India".

Niche market leaders

Deryck Noble-Nesibtt, who manages the fund with the best record in UK smaller companies over three years, Close Special Situations, says: "Engineers and industrials have done well, but that sector has been decimated over the decades. What's left are some global leaders in niche markets."

In total, engineering and industrial stocks make up only about 20 per cent of the shares in the small-cap end of the London Stock Exchange. The rest are companies such as retailers, housebuilders and specialist lenders. Many were hit hard by the recession, and the rise in share prices over the last year represents a recovery from crisis lows.

Wright is optimistic that investors coming on board now can still make decent profits. At Close, Noble-Nesbitt is less sanguine. He thinks global risks, from the European debt crisis, to inflation in China, to unrest in North Africa, make the macro-economic outlook very uncertain, and has taken a defensive position in his fund.