As investor confidence returns to the market, smaller companies have historically outperformed larger by 5%-8%, compared to an average relative underperformance of 4.2% in the initial stages of an economic downturn
The prospects for UK smaller companies look excellent, with a combination of strong earnings forecasts, low valuations and the increased appetite for growth companies as economies move out of the current downturn, allowing them to outperform their larger counterparts.
This was the case in the fourth quarter of 2001 as investors showed a willingness to look through weak corporate news and focus on the prospects for stronger growth in late 2002 and early 2003, and we expect it to continue as investor confidence returns to the market.
History shows that although UK smaller companies tend to see a delayed reaction to economic recovery, they tend to outperform more strongly as the economic outlook improves and investor confidence increases. In fact, as investor confidence recovers, smaller companies have historically outperformed larger companies by an average of 5.8%, compared with an average relative underperformance of 4.2% in the initial stages of an economic downturn. This makes smaller companies particularly attractive at a time when economic recovery is anticipated.
Last year was disappointing for equity investors, characterised by fear of a global economic slowdown. Given this weak background, it was not surprising that investors preferred the relative safe havens of the more liquid, blue-chip stocks at the expense of smaller companies.
The FTSE 100 dropped some 16% while the FTSE smaller companies fell 18% in 2001. This underperformance of smaller companies last year was not unusual and a similar pattern can be detected by looking at the performance of small versus large over a number of market dips in the last 10 years. (Source: Datastream)
The charts above show the performance of the FTSE SmallCap index relative to the FTSE 100 over different historic periods of market downturn and then recovery. Both illustrate underperformance by smaller companies in the period into and then initially out of the downturn as investor risk aversion prevails. As confidence builds, smaller companies show a much stronger tendency to rapidly outperform. A similar pattern is true for the market downturns in 1987, 1994 and 1998.
Smaller companies are also compelling in terms of their earnings forecasts for 2002. If we consider the different composition of the large and small-cap indices, it is not surprising that earnings for the FTSE 100 as a whole are forecast to grow quite modestly over the year.
This is largely due to the weighting of the oil and gas sector in the large-cap index, where earnings are forecast to decline significantly over 2002 compared to 2001. By comparison, small-cap earnings are forecast to grow by some 14% in 2002 helped by recovery in areas such as IT software. For those investors looking for exposure to higher growth, smaller companies look attractive.
Despite the fact that growth is forecast to be higher for smaller companies, there is still a significant valuation discount between the small and large-cap indices, with SmallCap some 30% cheaper than the FTSE 100. Digging deeper into relative sector valuations, small-cap IT software and IT hardware and other higher growth areas such as support services and media also emerge as better value compared to their large cap equivalents.
In fact, every small-cap industry group apart from financials stands on a valuation discount to the FTSE 100. Although small caps have stood on a discount to large caps since 1994, the current discount is at the bottom of the range over this period, highlighting the potential for recovery as confidence returns.
Historically, smaller companies tended to lag their large-cap peers when it came to timeliness of earnings downgrades. We could still expect to see further downward revisions for smaller companies at this stage of the economic cycle.
However, more recent data has shown this is no longer the case. The earnings revisions cycle for smaller companies in the UK has now passed its low-point, suggesting yet another reason why now is a good time to invest in smaller companies before this earnings growth is more widely recognised by the market.
With this more positive economic backdrop in mind and growing signs of an end to the global slowdown, we now have a more positive outlook on the economically sensitive areas of the market.
We particularly like companies that have both a lower cost base, but that should also see sales recover. Profits will therefore be higher this year through a mixture of the group's own internal moves and a market recovery, the so-called double-whammy effect. The ability of management to respond to changing market environment is a vital element in our fundamental research, and we have recently identified several interesting companies with compelling restructuring stories.
A leading example is the Management Consultancy Group, which provides consultancy services to industrial companies. The new management, appointed in early 2000, has successfully repositioned the company. The restructuring and focus on client cost-cutting is highly attractive in the current economic environment.
Another favourite is NHP (Nursing Home Properties), owner of nursing homes across the UK. The new management has successfully repositioned the financial structure of the company, which had caused near collapse in the past. The Group homes are now managed by larger, more professional entities reducing the risk of poor service and rent default. In addition, the political landscape is moving towards a solution to the problem of long term care, which given NHP is the largest owner of residential care beds in the UK should be to its long-term advantage.
We also like Charter, the global manufacturer of welding and air handling equipment, which is more exposed to the economic cycle. After a difficult year in 2001, which saw large lay-offs and disposals of non-core assets, the new management should see the benefits of this tough strategy bear fruit in 2002. The company's exposure to the capex cycle and the US economy should support strong growth this year as these areas improve and we have already started to see some evidence of a business turnaround come through.
In the media area, we like the niche magazine publisher Future Networks, which specialises in the number one PlayStation 2 magazine in the UK. The company is a likely beneficiary of the upswing in the games market following the introduction of the PlayStation 2 and the new X-box platforms. We also believe the new management introduced in 2001 will be successful in repositioning the Group's cost structure and we are confident the company will benefit as advertising revenues improve.
We have also recently added Azlan to the fund. Azlan is the leading pan-European distributor and provider of training for networking products. The share price is currently low, but we believe the company should deliver strong growth as the economic recovery strengthens.
We expect Azlan to benefit from consolidation in its market as the product providers, such as Microsoft, seek to reduce the number of their distributors.
Low valuations, strong growth and a favourable market environment are the key elements to successful investing in UK Smaller companies.
We believe that with these factors in place, this is the right time to invest in UK smaller companies. As investor confidence returns to the market we are confident that the outlook is bright for long-term investors in the asset class, and we see big potential in smaller companies.
History shows that small companies tend to outperform as the economic outlook improves and investor confidence increases.
Smaller companies are also compelling in terms of their earnings forecasts for 2002.
Despite the growth forecasts for smaller companies, there is still a significant valuation discount between large and small-cap indices.
Future World funds
Square Mile’s series of informal interviews
Achievements, charity work and other happy snippets
Latest news and analysis
When is a refund allowed?