Small-cap stocks in the US have so far weathered the deteriorating credit market conditions better than their international peers. According to Credit Suisse, however, the situation, is looking increasingly anomalous and is likely to change as the effects of the liquidity crunch catch up.
US small caps have surprisingly outperformed their large-cap peers for much of the year, continuing their seven-year stretch of outperformance vis-à-vis their larger compatriots. They are now starting to look conspicuously expensive, however, particularly as smaller, lower -rated borrowers should be expected to fare less well in an economic slowdown.
Tough terms
Indeed, according to Credit Suisse, widening credit spreads for lower-rated companies suggests that smaller companies will soon find the commercial bank loans available to them being offered on increasingly tough terms. This does not bode well for smaller companies, among which business confidence is already at recessionary levels.
The outperformance of US small caps so far this year is noticeably different from that of small caps in the UK, whose stocks have been among the hardest hit from investors’ rising risk aversion and flight to "safer" assets and where small caps have now fallen to the extent that they are starting to look on the cheap side.
The global liquidity crunch has put an end to an exceptional run of outperformance by small cap stocks worldwide. The Hoare Govett Smaller Companies Index (HGSC), which measures the performance of the smallest 10th of UK companies measured by market cap, has achieved annual returns of between 20% and 40% over the past four years, outrunning the FTSE All-Share index by 7% to 20%. Over the past nine years, the HGSC has returned 156%, beating the FTSE All-Share by 95%. According to research conducted by ABN Amro and the London Business School, a £1,000 investment in 1955 in the HGSC, with dividends reinvested, would today be worth £2.76 million, compared with £0.59 million if the investment had been in the All-Share.
In 2007, however, the HGSC gave a total return of −5.9%, an underperformance compared with the FTSE All-Share’s 11.2%. The smaller the company, the worse its performance tended to be.
Small-cap outperformance over the past few years has been an international phenomenon. The annual ABN Amro London Business School study showed that small caps outperformed large caps in most of the 21 markets it examined between 2000 and 2007.
As the credit crunch continues, however, small caps are likely to suffer disproportionately as investors turn to the perceived safety of bigger companies and judge that when it comes to surviving an economic slowdown, size does matter.