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QE's small-cap winners

Quantitative easing boosts small-cap shares. These are the ones that have outperformed in previous QE-driven rallies
June 26, 2012

With the eurozone remaining mired in economic and political purgatory, the UK economy back in recession and all indicators in the US pointing towards a slowdown in its economic recovery, the stage is set for more quantitative easing (QE) - and that could be good news for economically-sensitive and high-beta stocks.

If equities react as they have done to the past three bouts of QE, with a strong and sustained rally, investors should look to position themselves in those sectors and companies that are likely to rise the highest when the tide turns. Taking the lead from previous QE-fuelled rallies, this means switching away from defensive sectors into riskier assets and also looking lower down the value chain at smaller companies.

Smaller companies have led the way in previous rallies. For example, following the Federal Reserve's QE1 and QE2 programmes, which began in November 2008 and August 2010, the Aim market and the FTSE Small Cap index substantially outperformed the FTSE 100 (see table). The third major QE-fuelled rally occurred in the three months that followed the European Central Bank's LTRO programme in late December 2011 - and once again blue chips were left eating the dust of their smaller brethren.

IndexQE1QE2LTRO
FTSE Small Cap30%17%17%
FTSE Aim31%41%19%
FTSE 1005%18%9%

Source: Thomson Reuters

A matter of time

That's because smaller companies have higher betas and appeal to risk-tolerant investors. You should think about opening positions soon, because a further round of QE could be just weeks away. At June's Bank of England Monetary Policy Committee meeting, governor Sir Mervyn King voted in favour of expanding the UK's asset purchase programme, but his stance was narrowly defeated on a 5-4 majority. With the Bank professing grave concern about the impact of the eurozone's woes on the UK's already-flagging economic recovery, the vote could go the other way at the 2 August meeting.

Similarly, in the US, the Federal Reserve opted merely to extend the Operation Twist programme, but if economic indicators continue to deteriorate as rapidly as they have, then it seems likely QE will be next - and better for the Fed to move quickly so as not to appear to be influencing the autumn's presidential election.

The European Central Bank has so far avoided QE in the UK/US mould, preferring instead to lend directly to banks. But with contagion still threatening to engulf Spain and Italy, and no durable political solution in sight, it too may be forced to cut interest rates further and act to keep sovereign bond yields down.

With the heat coming out of commodity prices, and oil in particular, one of the major concerns about QE - that it fuels inflation - has eased. And, rightly or wrongly, markets have begun to enjoy the rush that QE has given them. In fact, equities enjoyed a surge just last week on hopes of QE being announced by the UK and US, only to be disappointed in the aftermath of the respective central bank meetings.

Get your fix

The sectors that gain the most from QE are the cyclical ones - anything exposed to improved consumer sentiment or commodities, which are also QE beneficiaries. In the past, these have included industrial metals and oil equipment and services, personal goods, technology hardware, industrial engineers, software and electricals (see table).

Safer, more traditionally defensive, sectors have performed less well during the past three bouts of post-QE buying, with utilities and mobile telecommunications stocks faring poorly relative to the market, as did supermarkets and food producers.

Sector QE1QE2LTRO
Oil services & equipment37%25%19%
Basic materials49%13%7%
Chemicals 38%22%22%
Industrial engineering45%21%15%
Auto & parts53%21%15%
Personal goods60%5%19%
Software & computer services44%31%11%
Technology hardware & equipment47%21%11%

Source: Thomson Reuters

Aim's big natural resources contingent is an obvious beneficiary of rising commodity prices, which boost both profits and cashflow and the value of reserves still in the ground. However, such shares are also very sensitive to stock-specific news about new discoveries and fund-raisings.

One way of avoiding this is to consider Anglo Pacific Group. This is a mining royalty company - it takes stakes in producing assets that then provide it with a royalty stream - so it is exposed to rising commodity prices, but not so much to company-specific events. No surprise, then, that in all three periods it outperformed the FTSE Small Cap, with rises of 34 per cent, 28 per cent and 22 per cent respectively. Other strong performers from the resources sector include Aim stocks such as Afferro Mining, Amerisur Resources, Arian Silver, Bowleven, Cluff Gold, Ithaca Energy and Mwana Africa. These represent a wide spread of resources companies from iron ore to silver, gold and oil and also companies at various stages of development. So QE has tended to boost the resources sector almost across the board.

But what about other sectors? Some investors may shy away from buying economically-sensitive stocks, such as industrial distributor Brammer, in our troubled economic times, but in the last three post-QE periods Brammer's shares have risen by 29 per cent, 53 per cent and 39 per cent, respectively.

As equities have risen in post-QE rallies, so have companies who are directly exposed to the health of the equity markets such as fund manager Impax Asset Management, wealth manager Brooks MacDonald and brokers Daniel Stewart, Panmure Gordon and WH Ireland. Technology stocks have also benefited with companies such as Forbidden Technologies, semiconductor wafer maker IQE and sensor technology specialist Zytronic all beating the market rise.

Even some consumer-facing businesses have thrived with online retailer Asos, airline and logistics business Dart Group and restaurants group Prezzo also shining. Other notable outperformers from the Aim market include coin and collectibles specialist Noble Investments, recruiters Impellam and Staffline, wine retailer Majestic Wine and food producer Real Good Food. On the FTSE Small Cap index, both LED distributor Dialight and industrial filters specialist Fiberweb stand out.

FTSE Small Cap Stars

CompanyQE1 QE2LTRO
Anglo Pacific 34%28%22%
Brammer29%53%39%
Dialight26%38%21%
Fiberweb25%63%25%
Management Consulting 18%30%14%

Source: Thomson Reuters

Aim's outperformers

CompanyQE1QE2LTRO
ASOS28%112%32%
Afferro Mining131%224%77%
African Minerals1600%36%23%
Alkane Energy54%37%17%
Amerisur Resources50%68%50%
Arian Silver32%418%47%
Avesco27%44%16%
Bowleven31%101%36%
Brooks MacDonald25%29%19%
Cenkos Securities20%5%35%
Cluff Gold107%42%25%
Daniel Stewart Securities31%63%50%
Dart Group 138%30%9%
Forbidden Technologies81%61%115%
Greatland Gold57%97%36%
Idox23%46%16%
IQE13%131%39%
Impax Asset Management39%36%13%
Impellam30%42%29%
Ithaca Energy151%52%55%
Majestic Wine34%31%18%
Noble Investments24%57%19%
Pilat Media Global27%32%28%
Prezzo34%30%23%
Solid State21%32%30%
Real Good Food118%49%40%
WH Ireland15%39%45%
Xcite Energy413%428%63%
ZincOX Resources141%48%40%
Zytronic31%27%29%

Source: Thomson Reuters

 

IC VIEW:

With QE looking increasingly nailed-on for later this summer, equity fans are limbering up for another risk-on rally. Getting in ahead of such a rise poses a risk should central bankers resist, but that looks extremely unlikely. Timing will be everything with the next bout of QE, but those who get it right could be handsomely rewarded.

 

FAVOURITES:

There are a host of candidates for potential outperformance should another bout of QE be unleashed across the developed world. Among our top picks are broker WH Ireland, whose own self-help turnaround strategy over the past two years has put the company in a healthier position.

We also like Dart Group which, although exposed to the highly cyclical holidays and logistics sectors, has maintained an impressive growth rate through the recent tough economic period. In the resources space, we like companies such as Ithaca Energy and Cluff Gold, which should both benefit if commodity prices spurt upwards once again. Indeed, gold companies such as Cluff often thrive in periods of inflation, or when higher inflation is feared.

In the technology space, we like IQE which is expecting an uplift in growth from a recent acquisition. We also rate Fiberweb as a buy and like Dialight for its consistent strong performance. On the consumer side of things, online retailer Asos has thrived in previous post-QE rallies and recent strong results mean it is likely to remain popular with investors.

OUTSIDERS:
Traditional defensive stocks such as utilities are under-represented on the Aim and FTSE Small Cap indices, but one sector that seems to have underperformed pretty much across the board in previous periods is the property sector. FTSE Small Cap companies such as Capital Regional, Development Securities, Helical Bar and LSL Property Services, and on Aim, Ashley House and Dolphin Securities, all noticeably underperformed their respective markets in previous post-QE periods. Other Aim companies to miss out on the previous market rallies include biotech business e-Therapeutics, shipping business Hellenic Carriers and IT group Maxima Holdings.