Last year was one to forget for investors in small cap stocks. In the UK, for example, the Hoare Govett Smaller Companies Index (HGSC) - which accounts for the bottom 10 per cent of the UK market - slumped 40 per cent. This dreadful performance was by no means unique to the UK. In only three countries – Ireland, Belgium and Japan - did small caps (as defined by the MSCI world indices) outperform large caps. And in both Belgium and Ireland this outperformance was only due to the dominant weighting of the imploding banking sector in their large cap indices.
Several factors help explain the poor performance of small caps. In the UK small caps tend to be overweight economically cyclical sectors such as industrials, travel and leisure, construction, and real estate (though the absence of banks was a major plus). This means the sector tends to perform poorly in an economic downturn. Analysts at Blue Oar Securities point out that during the last downturn between August 1988 and November 1992 the HGSC underperformed the All-Share by close to 43 per cent.
Beyond the poor macro backdrop one of the main reasons for the weak performance of small caps relative to the wider market in the current cycle has simply soaring risk aversion (this happens in all downturns but has been particularly acute in the current cycle). In the second half of 2008 cash and cash proxies such as gilts repriced upwards against all other assets as investor sought liquid, risk free asset classes. As a result the more illiquid the segment of the stock market – the worst it performed. The FTSE 100 (which fell 28 per cent) outperformed the FTSE 250 (down 38 per cent) and the FTSE 250 in turn outperformed the FTSE Small Cap (down 49 per cent). The wooden spoon went to the highly illiquid Aim index with a savage 61 per cent decline.
After such huge falls it should be no surprise that many investors are asking themselves whether small caps offer compelling value. At Credit Suisse Asset Management (CSAM) we believe that although the next 6-12 months could prove testing for small cap investors, today's market offers an attractive entry point for those with a long-term time frame. The reasons for this positive stance are several.
Valuation
The best starting point for evaluating the attractiveness of the small cap sector in today's markets is valuation. Small caps aggressively de-rated in 2008 with the historic P/E on the HGSC halving during 2008 from 12x to 6x earnings. Though the de-rating was painful for investors at least it is clear that unlike some more illiquid asset classes, such as commercial property where investors remain unsure of the true market clearing price, the sector has endured a major valuation adjustment.
Investors have not been offered such low absolute valuations since the 1980s (see chart 1). Over the past three decades, for example, the average P/E ratio of the HGSC has been around 13x earnings, so as Professors Elroy Dimson and Paul Marsh in their recent annual study of the HSCC index point out, in theory profits could halve and small cap UK equities would still be reasonably valued compared to their recent history.
But absolute valuations do not tell the whole story. It is also important also to examine where small caps trade relative to the rest of the market – and compare this to history. Here the picture is also reasonably encouraging. At the end of 2008 the P/E relative on the HGSC was 0.88 compared to the FTSE All-Share (this is calculated by dividing the P/E of the HSGC with the main market). Even if we adjust for loss making banks in the FTSE 100 the HGSC still trades at a discount to the wider market. Sure, small caps have in the past fallen to greater discounts to the wider market – most notably in 1999 when large cap growth stocks were in vogue – but 0.88 is towards the lower end of the historic range.
On prospective multiples the HGSC at the start of 2009 traded on 7.6x earnings after adjusting for loss makers and nav sectors. However this ratio is predicated on a very modest 0.6 per cent decline in earnings for index in 2009 (using consensus numbers). In our view given the weak macro outlook this looks completely unrealistic (in order to avoid such problems some investors look at cyclically adjusted P/Es which take average earnings over a 10 year period). It should be noted, though, that even if we adjust forecasts for more realistic earnings outlooks valuations look far from extended by historical standards. It is difficult not to conclude that current valuations in small caps represent an attractive entry point.
Risk appetite at record lows
The lower liquidity and higher beta characteristics of small caps has historically resulted in the sector having a high correlation with proxies for risk appetite such as credit default swaps and credit spreads. It will come as no surprise, therefore, that the sector has performed poorly against a backdrop of ballooning credit spreads in Western markets. In 2008 for example, the spread between US Treasuries and BBB US Corporate debt surged to over 750 basis points. Such spreads had not been seen since the Great Depression.
In the UK a good proxy for risk appetite is the spread between 10 year UK Gilts and BBB Corporate bonds. Typical BBB Corporate Credit now trades around 350 basis points over 10 year Gilts compared to only 50 basis points two years ago. While such a wide spread could be simply be an indication that gilts are overvalued it does give a good indication that risk aversion is at extremely high levels.
We view this high risk aversion as positive for the long-term outlook for small caps. Far better to buy into the sector when investors are wary and spreads are high than at a time when investors are complacent. Sure, spreads could widen even further, but there is a good case to argue that unlevered capital will soon view risk assets such as small cap equities as very attractively priced.
Is any rally likely to be thwarted by redemptions?
Many investors concede that small caps appear attractively priced – and that with risk aversion at high levels today could be an attractive entry point. However some fear that attractive valuations could be undermined by the impact of fund redemptions. We concede that hedge funds – which became extremely active in the FTSE 250 (both on the long and short side) – are likely to be far less of a force going forward in the UK small cap arena. We also fear that US institutions - which also became more active in the UK small cap space in recent years - may remain wary of the sector thanks to the weakness of sterling. At the same time private equity is unlikely to return as a major force to the sector until debt markets recover (which may be happening as LIBOR falls) and the economic outlook stabilises. Certainly there have been some isolated instances of private equity activity in the last year – such as the attempted purchase of Dmatek by LMS Capital – but for the most part private equity has been conspicuous by its absence. Meanwhile many traditional long only fund managers may be sitting on large cash piles but much of this will probably be soaked up by the raft of fund raisings likely in 2009.
We concede, therefore, that the marginal buyer will be far less in evidence in the small cap sector over the next 12 months. So with few marginal buyers will the sector be destroyed by waves of redemptions? This is a major concern as forced selling can wreak havoc on an illiquid asset class. However we think these fears can be overstated. The UK investor – both on the retail and institutional side - has been is a net seller of small cap funds for the past 10 years. This selling peaked in 2005 with a net outflow of £1.5bn from small cap funds – despite the sector being in the middle of a full blown bull market. In short small caps do not face the problem of being a "hot" asset class which attracted huge amounts of capital at the peak of the market – unlike technology funds in 1999/2000 and property funds in 2006-07. It seems unlikely, therefore, that despite attractive valuations the sector will be crushed by redemption driven sales.
Given the combination of attractive valuations and risk appetite at record lows we see the small cap market as an attractive space for investment at present – at least for those with a medium to long-term time horizon. It may be also worth noting that in the only other year that the HGSC suffered a comparable decline to that of 2008 – namely 1974 – the index rebounded 116.3 per cent the following year. And that was despite 1975 seeing ongoing economic contraction in the UK. To us that bodes well for a recovery in small caps during 2009-10. It is also difficult to ignore the superb long-term performance of small cap stocks in markets throughout the world. In the UK, for instance, the HGSC’s real return with dividends reinvested since 1955 is 8.5 per cent per annum. That's more than 2.5x the return generated on the All-Share.
James Chapman manages the Credit Suisse Smaller Companies Fund
