Outperformance in small caps is difficult to sustain

The small cap rally shows no sign of running out of steam although even small cap managers think it cannot continue at its current pace.

In the year to date the asset class has risen some 33%, buoyed by the strength of the UK economy, ongoing corporate activity and the relatively cheapness of small caps.

Catherine Stanley, UK fund manager at Framlington, says: "We are not going to see another 33% rise - that would be too much to hope for but over the year we expect small companies to outperform."

A more cautious David Taylor, head of UK smaller companies at HSBC, adds: "Predictions are difficult although small companies are still relatively cheap. However, you have to think there could be a slight shift in what has driven the market so far."

John Thornton, UK fund manager at Aberdeen, believes a small cap portfolio can outperform but only if managers rely on stock picking. He adds: "It will come down to those companies that perform well in profit terms and deliver growth that is as good, if not better, than the market expects."

Stanley believes one reason for the small cap revival this year is the simple fact that the asset class has produced poor share price returns for too long.

She says: "Small companies have underperformed for the past four years so it was about time the market rallied. Last year was a total disaster both in terms of absolute and relative performance - the Small Cap Index being left behind by some 24%."

The reason, she says, was a slowing economy had begun to add weight to fears of recession.

Stanley adds: "This year has seen a turnaround in economic circumstances while corporate activity has helped to buoy the Small Cap Index and promoted interest in the sector as a whole."

Taylor points to four main driving factors - the economy, a wide small cap discount, corporate activity and good liquidity levels.

He says: "Small companies tend to do well when the rest of the economy is growing. At the start of 1998 small companies were on a 40% discount and now the liquidity environment is good. A heady influx of corporate activity has kept the market strong and to a point it has been self-fuelling.

"Fund managers have probably been surprised by the number of bids for small companies and many have seen good returns. Smaller companies are higher risk but produce higher reward. However, when the economy is going in their favour the risk factor reduces."

Thornton says: "From 1996 to 1998 large caps outperformed small caps. As the economy slowed and inflation came down, nominal growth became low and profits disappointed in smaller industrial areas."

In a low inflation environment with tough sales growth and high-street prices under pressure, it was only larger companies that managed to get earnings up. As a result they were rerated against the Small Cap Index.

Robyn Hall

bull points

l Positive interest rate environment.

l Corporate activity in sector.

l Small caps still look cheap.

bear points

l Small caps have already done well.

l High growth needed for outperformance.

l Inflation fears on the increase.

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