Small and medium-sized companies, as represented by the Frank Russell 2000 Index, have outperformed their large counterparts by about 30% since the end of March 2000
Everyone believes they know the direction of the US equity market over the past 18 months ' a gradual downward slide. Since the heady days of the bull market in early 2000, the S&P 500 Index has come off by almost a third and received wisdom is that things are not getting any better. This hardly seems to be a compelling investment proposition.
Of course, this is not quite true. The market seems to have stabilised at the levels seen in mid-1998, before the technology bubble began to inflate. It is certainly down by about 5% since the start of the year but has still rallied by 13% from the low point reached in the wake of the events of 11 September.
This gradual recovery is no mean feat, considering the concerns about recession and the events of 11 September that troubled investors earlier in the year. On top of this, the Enron collapse led investors to question the aggressive and questionable accounting practices of several high-profile US companies. These concerns spread to several other large-cap stocks, such as Tyco and Worldcom, and, in turn, to the market in general.
Some 11 successive interest-rate cuts from the US Federal Reserve since the start of last year, totalling 475 basis points, have injected a tremendous amount of liquidity into the financial system, helping stabilise the economy and support the equity market. This has not been the sole reason for the recovery but is possibly the major one.
The news on the economy is generally good, with most indicators pointing to an end to what has proven to be a mild recession. The job market appears to be stabilising, manufacturing activity is beginning to pick up and consumers are increasingly confident. Any threat of inflation looks to be minimal.
What has passed by mainly unnoticed is the bull market in smaller and medium-sized companies in the US. It has crept along so quietly and inconspicuously that you could even call it a stealth bull market. Headlines tend to focus on the large-cap indices such as the S&P 500 and Dow Jones but these are dominated by the top 50 stocks and are less representative of the rest of the market.
In fact, small and medium-sized companies, as represented by the Frank Russell 2000 Index, have outperformed their large counterparts, as represented by the Frank Russell 1000 Index, by about 30% since the end of March 2000. This is clear from the graph above, where the upward trend in the moving average line shows the relative outperformance of smaller company shares over the past two years. Many smaller and medium-sized companies are back within 5% of their all-time highs.
What does this mean for investors? The first thing to observe is that this is not just a feature of the US equity market but rather a global trend. US small and medium-sized companies have rallied strongly but so have their counterparts in Continental Europe and the UK, for example, during the same period.
Essentially, small and medium-sized companies are cheaper than larger companies, and more leveraged to the economic upturn that we are now seeing. The US economy grew by a strong 5.8% in the first quarter of the year, while rising industrial production and continued strength in consumer spending all point to the recovery staying in place at a stronger rate than recent fears would suggest.
Furthermore, this improving economic data, along with the recent favourable productivity and unit labour cost reports, points to a corporate earnings recovery that could surprise on the upside. The situation is similar in most global economies.
The universe of stocks making up these smaller and medium-company indices tends to have higher relative weightings to the economically-sensitive areas of the market, which benefit most from any improvement in the economic background. In this way, the smaller and medium-sized indices typically have a higher weighting in industrials, consumer discretionary, information technology and materials sectors than the large companies universe.
This is balanced by significantly lower weightings in most other areas of the market, typically telecoms services, energy and, in particular, financials. Globally, smaller and medium-sized companies have also found a source of support in recent months from investors looking around for markets where there is still good potential for earnings surprise and high absolute returns.
There is now a widespread belief that returns from global equity markets are unlikely to be very compelling over the next few years. As a result, alternative investments such as hedge funds, emerging markets and smaller companies are currently the subject of increased attention from investors. A second source of support has been the sea change in the relative volatility of smaller and larger companies since the beginning of the new century.
In the past two years, many of the largest stocks have shown greater volatility than most smaller stocks, making them riskier in many investors' minds, a big change from the late 1990s. The collapse of Enron, perhaps the biggest corporate failure in history, marked a watershed in investor sentiment towards large and small companies. Right through the difficulties of the past two years, investors clung on to their investments in some of the largest US companies, hoping they would be able to meet earnings expectations.
The bankruptcy of Enron was the last straw as it came to light that that there had been a failure of corporate governance at the company, accompanied by accounting irregularities and an array of off-balance sheet deals deliberately designed to mislead investors. This forced investors to ask where the expected earnings growth was really coming from in some of the largest companies.
In turn, this has encouraged investors to move away from large companies with complex business models and ambitious targets for earnings growth in favour of smaller companies with simpler, more easily understandable business models. The old adage about only investing in companies you understand has come back with a vengeance and we believe this is one theme that will persist for some time.
One company that illustrates the theme of simplicity, coupled with an attractive growth rate and valuation, is Pactiv Corporation. This manufacturing company makes basic consumer products such as plastic food bags, rubbish sacks and disposable tableware. It is not a glamourous business but it is steady and reliable, with a straightforward business model.
Operating from Illinois, we expect this relatively small and nimble company to generate strong earnings growth of more than 20% per year for the next couple of years. The shares are currently trading at a 40% valuation discount to the market.
We have sought to take advantage of this trend for smaller and simpler companies across all sectors. Within media, for example, industry giant AOL Time Warner has struggled to gain the expected benefits from the merger of internet service provider AOL with publisher and film distributor Time Warner two years ago. This culminated in a disastrous $54bn asset write-off in April and a management shake-up. Our preference instead has been for smaller rival Viacom. The business has greater exposure to the economic recovery, a more attractive valuation and a simpler, more intuitive business model.
So, the strong relative performance of smaller and medium-sized companies is not a new phenomenon. It has been in place since the end of March 2000, although few have noticed it. What happened at Enron earlier this year has acted as a further impetus by prompting investors to favour smaller, simpler companies.
We expect this trend to remain in place for some time and have attempted to capture it in our investment portfolios. However, as we have pointed out, this stealth bull market in small-caps has already been in place for two years and, in a number of cases, the attractive relative valuation of smaller companies has already been arbitraged away.
Rate cuts from the Federal Reserve have injected a great deal of liquidity into the financial system.
Smaller companies are generally cheaper than larger counterparts and more leveraged to economic upturn.
The Enron situation has prompted investors to favour smaller, simpler companies.
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