Investment: Few happy returns for the unloved small caps

ANYONE WHO invested in smaller companies last year will know only too well how badly they performed compared to the gung-ho FTSE 100 constituents.

The latest Hoare Govett index of smaller companies, published yesterday, underlines the point. Its study shows that in 1998 the return on its smaller companies index was the seventh-worst since 1955. The relative return, compared to the All-Share, was the third worst on record.

Hoare Govett's smaller companies index measures the performance of the lowest tenth by market capitalisation of the main UK equity market, excluding AIM stocks. The cut-off market value for the index is pounds 585m, although the average size is much smaller at just pounds 91m.

These stocks have been the great unloved in 1998, just as they were in 1997, and the pattern which emerged last year was also similar to that in the previous year. Smaller companies began the year well: indeed, during the early months of 1998 they outperformed their larger cousins. By May, the return on the HGSC Index was 4 percentage points ahead of the All Share.

But then it all began to go horribly wrong. By the year's end the smaller companies had produced a negative return for the year - of minus 4 per cent - coming in 17.8 per cent below the return for the All Share.

The critical period was a disastrous third quarter. During the July to September period when the stock market travail was at its worst, smaller companies bore the brunt. The HGSC Index's returns plunged by 21.8 per cent compared with a 12.5 per cent correction in the FTSE 100.

The process was another demonstration of the double whammy which often strikes the smaller companies: they seem to miss out on the euphoria that has fuelled the Footsie's charge, but when any correction comes, they get hit just as badly.

The record shows just how recently the divide between large caps and small caps has emerged, and how marked its has become. Between 1955 and 1988 the annual return on smaller companies was higher than the All-Share for all bar a handful of years. Their compound return was on average 6 per cent better than the All-Share.However, since 1988 they have only outperformed in three years, and the most recent of those was back in 1994.

The weighting of particular stock market sectors has been an important factor. The soaraway sectors of telecoms, banking and pharmaceuticals have represented a small fraction of smaller companies. But the unloved sectors of diversified industrials, household goods and textiles are all heavily represented.

The outlook , sadly, is rather depressing. According to ABN, although smaller companies look cheap with a p/e ratio of 12 compared to an average of 20 for the All-Share, they could become cheaper still. That is likely to lead to more public-private deals.

It may be that on fundamentals the smaller stocks are valued correctly and their larger brethren have lost touch with reality But until a little steam is taken out of the Footsie, ABN says, the smaller stocks will continue to struggle.