Secrets Of Success: Remarkable run for small cap stocks

There is lots of interesting meat in the annual London Business School/ABN Amro review of small cap performance, published this week. It underlines quite what a remarkable run small company stocks have been having since the end of the great 1990s bull market. In fact, there has never been quite such a sustained strong run before, at least as far back as the data complied by Professors Dimson and Marsh of LBS goes (which is 1955).

Last year was the fourth consecutive year in which the small cap stocks that the HGSC index follows have (a) risen by more than 20 per cent and (b) outperformed the market as a whole by more than 5 per cent. (The HGSC index tracks the performance of the bottom 10 per cent of stocks in the main UK market, as measured by market capitalisation).

There have been only two years in the last seven during which small caps have failed to beat the All-Share index, and in those two years (2001 and 2002) the difference was minimal, around 1 per cent.

During the past five years, small cap stocks, as measured by the index, have outperformed the market as a whole by more than 7 per cent compound each year; over 10 years, by just over 3 per cent; and over the full 50-odd years of data, by around the same percentage. No wonder that this unprecedented run of outperformance has prompted many value investors to start thinking that a reversion in this trend is overdue.

As always in investment, however, it pays not to anticipate a switch in market leadership until the evidence of a reversal in trend is clearly apparent: being too early can cost you an awful lot of money. After the panic attack in markets in May, small caps have continued to outperform, and the degree of outperformance has, if anything, been accelerating. It is not impossible that it could still run on into this year.

True, there are some warning signs that a top is near, such as the fact that the price earnings ratio of the small cap index relative to that of the All-Share index has risen to its highest level yet. According to Richard Rae of ABN Amro - which commissions the study every year - the valuations still do not look unreasonable, as the earnings forecasts for smaller companies have continued to be revised upwards in the past few months.

At 16 per cent, the growth in forecast earnings is nearly double the forecast growth rate of companies in the FTSE 100 index. (These calculations exclude asset-backed sectors such as mining and insurance, where p/e ratios are less appropriate).

On past experience, the key now is whether these earnings forecasts will be met, or whether the expected slowdown in the US economy, coupled with higher UK interest rates, leads to downgrades and profit warnings. Because they are more illiquid stocks, with high bid-offer spreads and narrow markets, investors caught holding small cap stocks can expect to suffer disproportionately if things start to go awry. In that sense, the stocks in the index are riskier - though the clear message of the study is that no long-term equity investor can afford to neglect this volatile but rewarding segment of the market (which is well covered by some excellent funds, incidentally).

Whether the same is true for the lightly regulated Alternative Investment Market (AIM) is another matter. AIM underperformed badly last year, as it has done consistently, the main problem being that the quality of companies coming to the market has been a real dog's dinner. The tax advantages of AIM stocks are great, but you really have to be very selective, and a good stock-picker, if you are to avoid the many stinkers.

As time goes by, I seem to spend more of my time looking at charts and less time looking at fundamental research. This, of course, is in defiance of conventional wisdom, which says that technical analysis, the science of chart reading, is a nonsense. But I was interested to read in hedge fund manager Barton Biggs' recent book, Hedgehogging, that he too, like Anthony Bolton, also spends more time looking at charts than when he started out.

Needless to say, looking at charts for evidence of the current balance between buyers and sellers is not the same as believing in some of the more advanced mumbo-jumbo (Fibonacci numbers, Elliott Wave Theory, etc) that tends to come with the territory. The best technical analysts are experienced investors who are good at reading how the market is behaving, not wild-eyed enthusiasts with whacky theorems that instruct the market what it should be doing.

One of those I talk to on a regular basis is Brian Marber, who has been doing technical analysis for 40 years or more. He had an excellent year in 2006, with his calls on gold and oil in the early part of the year being particularly cute. As early as the first quarter, when talk of gold at $900 and oil at $100 was commonplace, he was warning that these price targets were excessive - the result of the market's worst fault, which is mindless extrapolation. His view is that charts can never tell you precisely what the markets are going to do next, but they can certainly help to keep investors out of trouble by showing what is and what is not likely to happen.

This is how Brian sees the main markets at the moment (recognising that these trends can and do change quite quickly). Oil: "I'm looking for the price to reach $40-$45 [£20.30-£22.80] a barrel at least. Gold: it should fall over the next three months. If last summer's low gives way, $450 looks likely eventually. The dollar: the major trend is down, but it won't be if gold does what I think it will. Gold down, dollar up, and vice versa, is one of the most robust trends in all market history. Sterling: I am looking for a rise against the euro. The pound is not a long-term buy against the dollar unless it closes at $2.0250. Stock markets: the charts currently point to the US market, London and the Eurotop all going up.

jd@independent-investor.com