Small caps well worth a long-term bet

Many Irish private investors must be very relieved that the Telecom Eireann initial public offering arrived so successfully during the summer of 1999.

Perhaps partly because of the focus of attention on Telecom, most of the rest of the Irish market has continued to drift lower over the summer.

Those investors who have diversified overseas may have had something to cheer about and they would also have enjoyed currency gains as the euro weakened sharply in the first half of the year.

However, the euro seems to have finally found its feet and could well be the strongest major currency in the second half of the year which means that overseas investments could well suffer currency losses when translated back into Irish pounds.

While many market analysts continued to fret about sky-high valuations on Wall Street, it would be easy to assume that all company shares are standing on historically-high valuations.

Of course this is not the case and even in the US market there are many companies, particularly the smaller capitalisation companies, which often offer quite reasonable price earnings ratios and dividend yields. The general malaise afflicting the Irish market and in particular the smaller companies, has led to a situation where there are many companies with good profits and balance sheets standing on historically-low valuations.

So far in 1999 there has been some respite in the tendency for small stocks to under-perform their larger brethren across most markets.

The Irish market has also experienced some rebound in the fortunes of smaller companies; however, the recovery has been selective and has tended to be focused on those sectors which have experienced merger and acquisition activity. These include Powerscreen which is the subject of a takeover, and Heiton and Grafton Group where the latter has been building a stake in the former.

This patchy performance in the Irish small capitalisation sector is reflected in the year-to-date decline in the Small Cap Index of 2.1 per cent that is almost exactly in line with the decline in the overall market. However, this is much better than the decline of 13 per cent in the Financial Index.

The malaise affecting smaller companies worldwide seems unlikely to dissipate quickly as the large institutional investors continue to concentrate on the large companies. However, it should be a segment of the market that attracts increasing volumes of private investor interest.

For investors with patience, investing in a selection of small company shares offers the prospect of handsome returns. Valuations are extremely low for many small companies and in a low interest rate environment they are probably unsustainable over the medium term.

Many of these companies will either be taken over or will revert to being privately owned. For example, the prospective year 2000 price earnings ratio of companies such as DCC and Clondalkin Group are nine and seven respectively.

These are companies with very solid track records going back over many years and at their current prices they should prove to be very rewarding investments.

Even though the Irish small capitalisation sector seems destined to remain unfashionable for the foreseeable future, it could well produce rewarding returns for those investors prepared to invest selectively for the long haul.