Small firms could outperform big rivals

Sep 30 2009 by Andrew Miller, The Journal

SMALLER listed companies (or "small caps") tend to be particularly sensitive to the economic cycle as measured by both top-line revenue and profits growth.

There are many reasons for this. For example, many small companies may be focused on only a few product lines, limiting the diversity of their revenue.

They also tend to have a high ratio of fixed costs as a percentage of total costs in their business, meaning that their profitability is more sensitive to changes in revenue.

Small companies also tend to be more reliant on traditional bank loans than large companies, which can access the capital markets to raise finance.

It is perhaps not surprising then that in previous periods when the US economy has recovered from recessions, US small cap stocks have outperformed those in the large-cap sector.

This isn’t something that has happened by chance. Companies in the economically- sensitive “cyclical” market sectors tend to be smaller on average than those in non-cyclical industries (such as utilities or consumer staples).

For example, the Russell 2000, a popular US small company index, has relatively high weightings in the cyclical financial, industrial, and consumer discretionary sectors. By contrast the large company S&P 500 index has higher weightings in the “defensive” sectors, such as utilities, telecoms and consumer staples.

With the US economy on the road to recovery, we would expect that cyclical companies should see their earnings recover sharply. Other things being equal, this would favour small relative to large caps. Indeed, earnings for the Russell 2000 companies are expected to rise by more than 150% next year and nearly 50% in 2011, according to consensus estimates. That compares favourably to the 24% and 22% increases expected for the S&P 500.

Year to date, most equity markets’ indices are now much higher than they were at the start of the year and this is especially true of the small company indices in Europe. The anomaly so far is the US, where small caps are only marginally ahead of large caps so far.

Clearly there are still some concerns about whether small caps can outperform in the current recovery, especially as the domestic US recovery is forecast to be weaker than usual.

There are also worries that small caps could struggle to find funding, but the same issues apply to the European and UK markets as well and they have performed strongly thus far.

One specific US concern is the healthcare legislation currently being debated in Congress, which might require smaller companies to provide health insurance for their employees or pay a penalty.

But the publicly-listed companies in the small cap indices aren’t that small. Most already provide health insurance and the legislation might, in fact, enable them to obtain coverage at better rates.

In addition to the cyclical “recovery” argument, we are also encouraged by the relative valuation and earnings growth forecasts for the small cap sector. Comparing the dividend yields of small caps versus large caps stocks suggests small cap stocks still offer a fair valuation.

Andrew Miller is regional office head of Barclays Wealth in Newcastle