Small-cap stocks’ future looking uncertain

By Bryan Borzykowski | September 11, 2007 | Last updated on September 11, 2007
3 min read

Since the 1980s, small-cap stocks have had a good run, often outperforming the S&P/TSX. Small companies still have an important role in a diversified portfolio, according to Martin Ferguson, director and portfolio manager at Mawer Investment Management.

Speaking at the annual GGOF Investment Summit in Toronto, Ferguson explained to the audience that the compound annual rate of return for the BMO Small-Cap index, the benchmark for the industry, has been 11.9%, while the S&P/TSX Composite index has seen a return of 10.76. He says small-caps have the potential to decrease risk in a portfolio, which should give a 5% to 10% weighting to small-caps.

But the past three years haven’t been kind to this segment of the market. In 2004, small-caps underperformed the S&P Composite by 4.4%, and by 10.4% the year before that. That doesn’t mean 2007 can’t be a positive one for them, but with the market in a tailspin, the small-cap outlook isn’t so good.

“If the U.S. slips into a recession, this would definitely hurt small-caps, and we’d expect them to underperform,” says Ferguson.

To determine how well small-caps will do in the future, Ferguson says investors need to look at five factors.

“Small-caps are driven by secular trends,” he says. Between 1970 and 1986, “investors loved small-caps. They traded at premium values to large caps.” But from 1986 to 2000, small-caps were viewed as “risky illiquid companies.” Today, the negative trend has tapered off, and small-cap and large-cap stocks are performing relatively evenly.

Second, small-cap performance is based on cyclical factors. Ferguson says that the market does best right after a recession and gets worse near the start of one.

Third, sectoral trends have an impact on the success of small-caps. Last year, the industry fared better because small-caps have a heavier weight in the materials sector. But when financials do well, such as in 2005, small-caps suffer — the BMO Small-Cap index has 12.5% weighting in that sector compared to 30.5% for the overall S&P/TSX.

A fourth factor affecting small-caps is the income trust tax. Before Finance Minister Jim Flaherty’s announcement last October 31, income trust conversions helped small-caps. Since the announcement, everyone’s been hurt, including this part of the industry, which Ferguson says has been hurt “relatively more.”

Of all the factors, though, the fifth — psychology — could play one of the most important roles in determining the health of small-caps. “Investors can swing to small-caps if greed exceeds fear,” says Ferguson. “But fear can also exceed greed.”

So how do these factors affect small-cap stocks today? In terms of secular and sectoral trends, the drivers are neutral. Small-caps have had three years of outperformance followed by three years of underperformance, so secular trends are essentially balanced out. Sectoral trends are also not a factor right now, though they could be if the market turmoil continues to affect financials, in which case, this area would become a positive driver for small-caps.

Thematic investing isn’t big right now, so that falls into the neutral category as well.

What could have a negative effect on the small-cap market are psychology and cyclical trends. Ferguson says that “psychology was a positive driver until about-mid July,” but that’s changed in the past two months as more people have been dominated by fear than by greed.

Since then he’s re-categorized the psychology factor from a neutral to a negative driver.

As for recession cycles, the portfolio manager says we’re nearing another one and that we’re at the end of an economic cycle. Without any positive drivers, and with an unpredictable market, investors can expect small-cap stocks to have an uncertain future.

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Bryan Borzykowski