These two UK shares named among Top 20 small caps

Small has certainly been beautiful for investors this year after a significant and further outperformance by small-cap stocks against larger counterparts.

UBS has highlighted this trend in its European small caps Top 20, which features a handful of stocks of potential interest for UK investors looking toward 2018.

In the year to date, the broker notes that European small caps are up 10-14% on most indices and have outperformed large caps by 3-4% in a continuation of the record of the past decade.

The UBS list, which is based on the bank's coverage of 400 pan-European small and mid-cap stocks, certainly has an impressive record.

It is up by about 28% so far this year, outperforming the MSCI European smallcap index by 12%. In fact, since its inception in December 2006, the top 20 has outperformed every year and is up by 503% overall!

UBS has just added four new names to its rankings, including UK-listed Lancashire Holdings and Rotork. Those removed from the list because of recent outperformance include Ashmore (up 35% in the past year) and Derwent London (up 16% since January).

Vesuvius remains on the list, despite having risen 40.5% in the year to date. UBS has a price target of 660p on the engineering firm, which only joined the top 20 list in September, but has dropped 4% in the period since then.

Shares in Bath-based Rotork, which operates in markets where the flow of gases or liquids needs to be controlled, have been showing signs of recovery since falling to 156p in February 2016.

UBS's 'buy' rating and inclusion on the top 20 list is based on confidence that management will be able to restore margins back to the 25% level over the next five years.

It said: "Our analysis of the Rotork cost base suggests significant opportunities to lift operating margins.

"This contrasts with a share price that is pricing in no significant margin upside based on consensus revenue forecasts. Higher sales growth could be an additional kicker."

UBS has a price target of 295p on Rotork, which trades on a forecast PE multiple of 21.9 and dividend yield of 2.2%.

The bank is also interested in the potential for speciality property insurer and re-insurer Lancashire Holdings to benefit from localised price rises.

UBS analysts said: "It is small, nimble, and can react quickly as opportunities arise. Importantly, it does not need a broad-based market turn to thrive, just pockets of dislocation, as we now expect."

Lancashire's shares are currently 675p, having been as high as 759.5p in early November. UBS, which has a price target of 830p, reports a PE multiple of 12.9%, with dividend yield of 7.4% based on 2018 earnings forecasts.

After more than 10 years of consistent outperformance of small caps vs. large caps, the question now for UBS is whether small caps look expensive.

However, it points out that European small caps still trade at quite reasonable multiples, with a PE of 15.4 for 2017 and 14.6 for 2018 - a slight discount to large caps.

While the outlook for 2018 could be a bit more difficult given the valuation levels, UBS points to three positive drivers to European earnings.

The first is GDP growth, which is likely to remain supportive for both top line and margins. There is scope for re-gearing of balance sheets and for M&A to affect small caps in particular, while there is the potential for a significant pick-up in capital expenditure.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.