Smaller stocks should continue to make gains

Investor: An insider's guide to the market: The Irish equity market has begun the year in fine fettle, with the ISEQ Overall index rising by approximately 4 per cent in the early weeks of 2005.

This has not been the experience of global equity markets, where the rally over the latter months of 2004 has not carried through into 2005. US share prices have faltered with the man indices down by about 2 per cent so far in January.

Some nervousness regarding the pace of prospective interest rate rises, combined with continued worries concerning the dollar, seem to be having a negative impact on market sentiment.

The release of data on the trade deficit showing that it hit a record high of $60.3 billion in November, up from the previous high of $56 billion in October, did little to bolster sentiment.

One theme that has been receiving keen interest recently is the sustained outperformance by small- and mid-capitalisation stocks in recent years.

In the second half of the 1990s large global companies dramatically outperformed smaller stocks. In part this reflected the fact that the technology, media and telecommunication (TMT) stocks tended to be large companies.

The euphoria surrounding the dotcom era drove the share prices, and hence valuations, of large companies to dizzy heights.

After the bursting of the stock market bubble in the early years of the new millennium there was a sharp reversal in the relative fortunes of large versus small cap companies.

In the US the outperformance of small- and mid-capitalisation stocks has now been running for five years. This pattern has been repeated in Europe and Britain.

In Britain, the FTSE 100 index, which consists of the largest 100 British quoted companies, rose by 13.6 per cent in 2003 and by 7.6 per cent in 2004. However, the FTSE 250, which consists of mid-capitalisation stocks, rose by 34.3 per cent in 2003 and by 19.6 per cent in 2004.

Several years of outperformance means that smaller companies are no longer valued at a discount to the large global companies. In fact, in many markets small companies are now valued at a premium to large companies.

This led many commentators to forecast that this phase of small cap outperformance would come to an end in 2005.

However, instead of large-cap outperformance, the mid-sized companies have made a stronger start to the year. For example, in Britain the FTSE 250 index recently touched a four-year high, while the FTSE 100 has struggled to make any advance in January.

The outperformance of the Irish market could also be part of this trend. Most of the shares quoted on the Irish exchange would be categorised as small- or mid-cap stocks.

The accompanying table lists a selection of the top-performing Irish companies over the past 12 months. Elan, which is in a special situation, tops the list, but the other companies are small by international standards.

A striking feature of this table is the high representation of building and construction-related companies, which include Heiton, Grafton, Kingspan and McInerney.

It is, in fact, often the case that small- and mid-cap companies tend to be disproportionately represented in sectors of the economy that are very sensitive to the economic cycle. In contrast, large companies tend to concentrate more heavily in stable and defensive sectors.

Therefore, the explanation for small-cap outperformance in recent years may have much more to do with relative performance between industrial sectors rather than size per se. For example, more than 25 per cent of the FTSE 250 index comprises construction and housebuilders, retailers and hotel stocks - all sectors that have benefited from strong British economic growth in recent years.

Despite the relative gains notched up by mid- and small-cap stocks over the past few years, Investor takes the view that this theme could run for another year or two in European markets.

Although Europe's economic growth has been patchy, on average economic growth should be reasonable in coming years.

Another factor that clearly favours smaller companies is the relative impact of the weakening dollar. Smaller companies tend to be more focused on their domestic markets, and therefore, on average, they are less exposed than larger global companies to the adverse impact on profitability of dollar depreciation.

A third factor that may benefit smaller companies disproportionately in 2005 is the continued rise in merger and acquisition (M&A) activity.

A particular feature of M&A activity over the past year is a shift in emphasis towards deals among smaller companies. This stands in sharp contrast to the wave of M&A activity in the late 1990s, which was characterised by mega-mergers involving very large companies. This likely ongoing interest in smaller companies should provide another layer of support to the market.