A record year for smaller companies is coming to an end with the prospect of more to come next year....
A record year for smaller companies is coming to an end with the prospect of more to come next year.
Why so? The drivers of this year's performance are still in place and are likely to accelerate next year. The economic upswing, confirmed by the Chancellor's recent conservative forecasts, will continue with growth rising further in 2001. This will be underpinned by continuing low inflation with interest rates rising modestly but still at historically low levels.
The valuation gap between smaller and larger companies, despite this year's strong performance, remains with small caps still standing at a significant discount to their larger brethren, there being also considerable valuation disparities within the small cap universe itself.
Corporate activity, which saw 10% of the FTSE Small Cap ex IT Index disappear in the first half of the year as a variety of corporate suitors sought out opportunities, is likely to continue next year. Venture capital funds, among others, remain liquid and eager to do deals.
While the general background for the UK Small Cap market remains positive, as ever, the sector disparities will remain wide. Many companies in the manufacturing sector, despite the prospect of strong top line growth, are likely to see shrinking levels of profitability as input cost pressures of rising raw materials and labour costs cannot be passed on to the end customer.
Those commodity businesses with no pricing power may have what seem to be attractive ratings but the prospect of 'profitless growth' means ratings may not be so cheap in reality
Where then is the outperformance likely to be found? Two areas currently look interesting.
The buoyant economy will lead to strong levels of consumer spending albeit the consumer will be more value conscious and more discerning on where to spend his or her money. Look therefore for consumer stocks with strong brands and pricing power involved in long-term growth areas. The smaller branded pub and restaurant groups, for example, with lifestyle brands that can be easily rolled out are still showing significant growth. Health club operators are taking advantage of changes in lifestyles to aggressively roll out their product to a market still years behind the penetration levels achieved in the US.
Information technology, that increasingly important part of the market, will again drive performance next year. While some of the IT staffing agencies and hardware suppliers have had Millennium Bug induced profit warnings the majority of pure software stocks have continued to sustain high double digit growth rates. The significant rise in the price of such stocks in the last few weeks indicates the markets final belief in the temporary nature of the millennium problem and the long-term growth trend.
What of the internet? While many of the pure web site plays offer valuation and revenue assumptions only for the true believers, the internet software and service providers provide a more robust earnings stream- business. E-commerce for example is forecast to reach $1.3 trillion by 2003 compared with $8bn in 1997, according to Forrester Research. Opportunities abound for the right software providers. Perhaps the right analogy here is the California Gold Rush - the majority of money to be made was supplying the picks and shovels, not panning for Gold.
Philip Harri is fund manager of the Credit Suisse Smaller Companies Fund
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