When is the right time for small caps?

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AIM and Small Caps - December 2013

There is a common preconception that smaller companies always do well coming out of a recessionary period.

This may be sensible as a rule of thumb, according to Standard Life Investments’ Harry Nimmo, who points to the spectacular returns seen by smaller companies as they came out of the bottom of a number of bear market phases – sparked by the Asian, Gulf War, banking and eurozone sovereign debt crises.

But David Coombs of Rathbone Unit Trust Management thinks, even as a rule of thumb, it’s too simplistic. The head of multi-asset, who also runs the multi-asset portfolios and Global Alpha fund, points to several factors driving company performance, regardless of size.

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In terms of operational performance, companies tend to be more efficient due to cost-cutting put in place during any preceding recessionary period, which he says is often a tailwind for earnings.

“Interest rates also tend to be lower coming out of a recessionary period and, therefore, companies can finance themselves more cheaply. Typically, sales also pick up during periods of economic growth.”

But he stresses these benefits are not exclusive to small caps.

Giles Hargreave, manager of several Marlborough portfolios focusing further down the market-cap spectrum, including the newly launched Nano-Cap Growth, Special Situations, MicroCap Growth and Multi Cap Income funds, takes the long-held view that smaller companies’ relative outperformance is irrespective of timing.

“You can’t really predict a point in the market cycle [when smaller caps will do better or worse]. The past 10-15 years have shown significant outperformance, in spite of a 12-year flight to safety being included in that, where people have been moving out of equities and out of small caps.”

Gervais Williams, managing director at Miton Group, says that since the start of the smaller companies index in the mid 80s, they have seen a prolonged period of outperformance, averaging roughly 40 per cent per year. But, he says, in the past few years, growth came from everywhere, with market-cap size irrelevant.

Mr Hargreave says 2013 is the first time in 15 years that people are switching back from bonds into equities, and is convinced small caps’ success shows no signs of waning. Mr Nimmo on the other hand is more bearish. He says the number of recent new issues is encouraging but believes after such a strong run, it might be time for investors to exercise a bit more caution.

“But I’m not fearful of that, because my portfolios are positioned at the more defensive end of my universe,” he adds.

Mr Coombs says that, regarding share price performance, smaller companies tend to be more depressed during recessionary periods due to their relatively higher risk profile – generally newer companies operating in rather niche sectors.

“Small companies also tend to be in a weaker negotiating position compared with larger companies when dealing with customers and suppliers, which also means they may get squeezed on the price of their inputs from suppliers, or may have less resource to chase up on missed payments by clients. When the economic outlook improves, these risks reduce and this is then reflected in share prices.”