In a climate of fear, when the markets are predicting economic doom and the bears are collecting the...
In a climate of fear, when the markets are predicting economic doom and the bears are collecting their coats from the cloakroom, it is usually small-cap stocks that get trampled in the ensuing stampede.
But when the bears head out of the woods, it is usually the small-cap sector that leads the way back. Small-cap shares almost always outperform their larger brethren in the first year after a downturn. It is only once the market has gained momentum that the large-caps come back into favour.
But, as we sit here, a quarter of the way through 2005, the small-cap story - especially in Europe - seems to still have credence and will not go away.
However, there are pessimistic soothsayers who are prophesising the bull-run for small-caps worldwide has run its course. They argue that small-caps are no longer good value relative to large-cap stocks. During the tech-driven boom of the mid-to-late 1990s, large-cap stocks - particularly technology stocks - reached lofty valuations. However, when the bubble burst, large-cap valuations were sent reeling.
They say that after years of relative outperformace small-caps can no longer be regarded as cheap on a valuation basis, and they have now reached and exceeded their average valuations relative to large caps. They say that small caps can only perform in surging equity markets and in the range-bound markets we have at the moment, only large caps can outperform.
Admittedly, few expected small-cap stocks to outperform for so long, continuing their run of form through 2003, 2004 and thus far this year. But if you look at the underlying fundamentals at play in Europe, this should not have come as too much of a surprise.
Although the eurozone has been comparatively indolent, there are a number of reasons for this, which can only help smaller European companies. Despite being sluggish, 2004 saw a number of positive surprises. Following the results season, over half of the reporting companies have at least matched consensus estimates, reflecting greater than expected cost controls, a little more growth in some domestic economies and perhaps excess conservatism from some analysts.
The real 'slugs' that have caused this sluggishness have been the larger companies, which, like in Germany, are going through a process of restructuring. As European economies are liberalised and the pervading interventionist hand of the state is lifted from the operations of many large companies, small caps thrive. They thrive for two reasons; firstly the smaller companies have not had to go through the pain of restructuring. They have tended to be left alone by the state government. Therefore they know how to run their ship in a streamlined and efficient way, and as the larger companies have had to trim their fat and reorganise, the smaller companies have been able to concentrate upon product development, design and sales.
Secondly, many smaller companies have been in those areas where they service the larger companies. An example of this is the oil sector. Oil is dominated by a few big names in Europe such as Total Fina Elf and Royal Dutch Shell. The giants have been making huge profits out of the rise in oil prices, currently somewhere near $55 a barrel. But there is a whole host of small caps that are involved in servicing the giants.
In Europe, small caps have outperformed large caps by 35 percentage points over the last two years (to 5 April 2005, HSBC Small Cap Index vs MSCI Europe) but it is not just economic recovery that has helped them: small caps are getting a boost from the currency market. European large caps, usually by their nature, are international companies, which mean that they have exposure to foreign currencies - most notably the US dollar.
The last year has seen the value of the dollar tumble. If the large caps do business with America, their customers pay them in dollars. They then have to convert these dollars into their own currencies. This is usually done at a loss as companies rarely have the expertise to play the international currency markets.
But small caps, by their very nature, are domestically based, so they get their products or services paid for in their domestic currency, hence they do not have this currency risk problem.
European small-caps tend to be nimbler and respond more quickly to an upswing and can also retract themselves quicker in worsening market conditions.
Putting the tech into protection
Square Mile’s series of informal interviews
Fallout from Haywood suspension
Launching later in 2019
£80bn funds under calculation