Global stock markets have rebounded sharply since March, prompting some observers to herald the...
Global stock markets have rebounded sharply since March, prompting some observers to herald the rally as the start of the next bull market. However, with underlying global economic growth still subdued, others now assume the rally has gone far enough. Our assumption remains that many asset classes offer the prospect of rising returns for some time following the bear phase of recent years ' one in which we have great conviction is the UK smaller companies universe.
Smaller capitalised companies in the UK have historically been viewed as strong candidates for generating premium earnings and dividend growth. The sector performed well throughout the 1960s, 1970s and 1980s relative to its larger peers. However, the pattern changed in the 1990s when smaller companies underperformed larger stocks.
During that decade, small-caps were adversely affected by several factors. Firstly, there were domestic macro-economic issues such as the period the UK economy was in an extended recession, until its withdrawal from Europe's Exchange Rate Mechanism (ERM).
Secondly, there were the international crises of the mid-1990s. These included Mexico's 'tequila' crisis, Russia's default with the International Monetary Fund and the collapse of Long Term Capital Management. This led to many investors to favouring assets that could, if necessary, be sold quickly.
This situation was rapidly compounded by Asia's financial crisis, which led to another serious bout of selling and severe turbulence across global financial markets, re-enforced investors reluctance to hold illiquid smaller businesses.
The build-up of the technology bubble towards the end of the 1990s might have been expected to favour the smaller company sector as a whole. But in the event, other than those directly in the TMT sectors ' telecoms, media and technology ' most smaller companies were deemed 'old economy', and performed no better than the overall market.
Finally, the bursting of the TMT bubble cost investors significant capital. As they scrambled to cut their potential losses there was a marked rise in the market's inherent illiquidity. This remained a dominant feature of the small-cap sector during the bear market, and persisted until March 2003.
So, having seen smaller companies fall 42.1% during 2001 and 2002, against a fall of 36.7% by their larger peers, (as measured by the FTSE Small Cap ex Investment Companies Index and FTSE 100 Index respectively), most institutional investors remained comfortable to remain underweight in the early months of 2003.
However, the period and scale of underperformance of the small-cap sector has given rise to an investment universe filled with rich pickings. Valuations still appear highly attractive ' both in relative and absolute terms ' and in our view there are a number of encouraging trends that should render the sector's prospects particularly favourable for quite some time yet.
For one, the UK economy remains comparatively resilient. The domestic sector of the economy ' an area to which smaller companies are naturally most geared ' has remained the principal support to broader economic growth, at a time when most of its western counterparts have come to a virtual standstill. Conversely long-term interest rates have fallen to their lowest level for a generation proving low cost cash for successful businesses. The combination of sustained trading conditions and cheap money is very good for much business.
Secondly, the universe is generating significant amounts of cash for shareholders. Shareholder dividends from smaller companies have been on the up across the board. More firms have been buying back equity, and a growing number of directors have been purchasing stock in their own companies, providing an effective testimony of their confidence in the future of their businesses.
A spate of management buyouts and a wave of merger and acquisition activity with a mounting number of bids coming from venture capitalists, also highlight the growing confidence in companies' future earnings growth potential.
Last, but not least, one of the most compelling factors that underscore the sector's positive outlook, is that most large-cap-based investment managers are still underweight smaller companies. The rise in the small-cap universe has caused institutional investors to underperform.
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