Small and mid cap stocks have had a reversal of fortune this year following their underperformance i...
Small and mid cap stocks have had a reversal of fortune this year following their underperformance in 1997 and 1998. Roddy Davidson asks if the FTSE SmallCap market can maintain its high returns
The opening months of 1999 have seen a striking reversal in the relative performance of the FTSE 100, the FTSE 250 and the FTSE SmallCap indices when compared with the experience of the past two years.
During both 1997 and 1998, the handsome returns generated by the UK equity market were heavily skewed towards a relatively small number of sectors such as banks, pharmaceuticals, telecoms and utilities, all of which feature a high concentration of large companies. As a consequence, the small and mid cap indices sharply underperformed, lagging the FTSE 100 by 25% and 13% respectively during 1998 and by 19% and 18% during 1997.
The story so far this year could hardly be more different, with many large sectors underperforming and the FTSE 100 only managing a return of 7% up to the end of May compared with gains of 24% and 26% for mid and small cap stocks.
The obvious question posed by this dramatic volte face is whether these themes represent a short-term correction or herald a more sustained recovery in the performance of small and mid-sized companies relative to their larger peers.
In essence, the debate hinges on the question of how well value-oriented cyclical stocks are likely to perform relative to longer-term growth stocks. Much of the recent strength exhibited by non-FTSE 100 stocks has centred on what are generally considered to be cyclical stocks in such economically sensitive areas as resources, basic industries and cyclical consumer goods. These areas tend to have a larger representation in the small to medium market segments.
Mining, forestry and paper, chemicals and distributors - some of last year's worst laggards - have now responded particularly sharply to a progressive improvement in GDP growth expectations. Estimates have been aggressively upgraded from their nadir last autumn (when many commentators were openly discussing the possibility of a global economic collapse), to a position where the notion of a soft landing is now being widely trumpeted. This view is reinforced by recent survey evidence from the CBI and improving data on housing and car sales. However, news from the high street remains rather mixed.
Our view is that the UK economy will show moderate growth during the current year leading to a further improvement next year when we expect GDP growth to return to its longer-term trend level of between 2% and 2.5% a year. However, we do not expect this scenario to generate any significant inflationary pressure and there is scope for further interest rate reductions before the end of the year.
Against this backdrop, the prospects for economically sensitive companies appear relatively benign and should be further enhanced by the lagged effect of earlier interest rate reductions. Investors tend to be less wedded to large liquid stocks during periods of economic stability, which will continue to help the smaller end of the market. These factors bode well for the relative outperformance of the small and mid cap indices, particularly given the differences in index composition already highlighted.
However, the sustained strength of sterling, particularly against Emu, re-presents a real caveat for export sensitive stocks. Sterling's current exchange rate of around three deutschmark to the pound is little changed when compared with levels prevalent 12 months ago.
Since then there have been seven base rate reductions, equating to a 2.75% loosening in monetary policy, providing exporters with little respite.
UK base rates have now reached their lowest level since 1977 but we see little reason for a significant depreciation in the sterling until there is a tangible upturn in activity within the economies of continental Europe. Another factor which should also have a positive impact on non-FTSE 100 stocks is their valuation levels. Despite recent outperformance there remains a real value gap between small and mid cap stocks and their larger counterparts. Brokers' estimates suggest that the P/E ratio of the mid cap index for the year to December 1999 remains some 25% below that of the FTSE 100. The gap between the P/E's of the small cap index and the FTSE 100 is even more pronounced at between 35% and 40%.
Despite this the earnings growth of the small and mid cap sectors is expected to exceed that of the largest 100 stocks and in many cases dividends, which are typically well covered by profits, should also see greater growth.
Corporate activity has become increasingly prevalent particularly among small and mid cap stocks. Around 10% of the constituents of the FTSE SmallCap Index at the end of September 1998 have subsequently been involved in some form of corporate activity and numerous others have been the subject of bid speculation. A total of 52 smaller companies de-listed during the first quarter of 1999 - a 27% increase on the same period in 1998 and almost double the number recorded during the first three months of 1997. We expect this pattern to continue based on a number of factors. First, the valuation levels highlighted above mean that many well managed, financially robust companies with good long-term profit growth prospects are now up for grabs at particularly attractive prices, resulting in a good deal of interest from overseas predators.
Second, there appears to be a growing realisation among the management of many of these companies that corporate activity may be the only way to boost flagging ratings. This mindset has already driven many of the deals alluded to above and has been firmly reinforced by an increasingly vocal and proactive attitude amongst frustrated institutio
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