Small-cap investors have been among the hardest hit by the turbulence in world financial markets with rising risk aversion prompting a flight into quality assets and more defensive sectors in equity markets.

Lacking the earnings power and liquidity of the blue-chips and seen as more exposed to the domestic economy, the share prices of many small-cap stocks have been severely hit since the onset of the credit crunch.

While the blue-chip FTSE 100 is 14 per cent off its June peak, the FTSE SmallCap index has slumped 25 per cent over the same period.

With markets so volatile and a possible US recession on the horizon, is the growth potential of small-cap stocks still attractive?

Graham Ashby, head of UK retail equities at Credit Suisse, and his colleague James Chapman, UK small companies fund manager, answer your questions below.

.....................................................................................................................

Can small-cap stocks outperform the large-cap stocks in the long or short term perspective in highly volatile markets? What are the differences between the small-cap stocks performance in the developed, emerging and frontier markets?
Viktor O. Ledenyov, Ukraine

GA: Traditionally, small cap stocks have underperformed large cap stocks when volatility has been on a rising trend, as seen in the final quarter of last year. This is generally due to increased risk aversion by investors who feel that larger companies generally offer greater diversification and stronger balance sheets.

However, as we have seen in February of this year, this is not always the case as UK small cap stocks significantly outperformed their larger peers. From my point of view, there are two main reasons:

a) UK smaller companies became quite cheap compared with their larger peers following their significant underperformance in the latter half of 2007.

b) UK smaller companies have much smaller exposure to current problem areas, such as the banking and pharmaceutical sectors.

In my experience, this would generally hold true for all equity markets - developed or developing. It’s also interesting to note that small cap stocks in developing markets such as China appear to have held up relatively well in the recent market setback as investors have used more liquid large cap stocks as a source of funds. As a result, most of the time it’s far better to look at companies from a bottom-up perspective (i.e. is it a good or a bad company, what are its prospects, and is it attractively valued) regardless of their size. Don’t forget that Bear Stearns was once a large cap stock!

JC: Historically small cap stocks significantly underperform large cap stocks in cyclical downturns. In the UK, for example, smaller caps most notable periods of poor relative performance vis a vis the wider market were in 1975, the early 1980s and the early 1990s. Only in the late 1990s – when large growth was in vogue – did small caps underperform during benign economic conditions. And it’s been the same in this cycle, with small cap shares down 17 per cent in the last six months alone compared to a 10 per cent fall in the wider market.

Despite the poor performance in the past 12 months, the long term performance of small caps in developed markets is spectacular. £1 invested in the UK’s Hoare Govett Smaller Companies Index in 1955, for example, would have grown to £2757 by January 1, 2008. In contrast, £1 invested in the FTSE All-Share Index would have only grown to £593. Over the long run, the HGSC Index has beaten the All-Share by 3.3 per cent per annum and similar levels of outperformance have been achieved in the US. Given the power of compounding, this leads to staggering differences in returns.

Interestingly this massive outperformance cannot be attributable to standard textbook arguments that investors are exposed to greater risk in small caps. A balanced portfolio of small cap stocks, for instance, has not proved in the past to be noticeably more volatile than the wider market. Research by the London Business School has shown that the volatility of returns on small cap indices has been only slightly higher than the All-Share.

.....................................................................................................................

What can we expect from UK small caps operating globally such as Kewill Systems or nCipher can they out perform blue-chips?
Clive Boulton, Bay Area Califiornia

GA: I’d rather not comment on these individual stocks, but it’s fair to say that not all smaller companies are domestic plays. As a result, investors should take the time to focus on each company’s attributes rather than looking from a top-down perspective.

JC: We do not own either of these companies in our portfolios so I’m afraid I’m not in a position to comment on their individual merits. As noted in the previous answer, though, small caps tend to outperform large caps in the long run.

.....................................................................................................................

What are the current price/earnings ratios of small-cap stocks? If small-caps stocks are currently undervalued, what possible catalysts will eventually release that value? Do you anticipate private equity funds buying into this segment of the market. What is your view on small-cap stocks in France?
Roger Springfield, Paris

GA: Once you strip out the distorting effect of investment trusts and loss-making companies, Blue Oar Securities calculates the prospective P/E ratio of UK small caps is currently at a similar level to large caps. However, you shouldn’t forget that you’re often comparing very different companies in terms of industries they operate in and financial strength, so you’re rarely comparing like with like.

There is also plenty of evidence to show that P/E ratios are not a particularly good guide to valuing companies. It’s far better to look at cash flow and cash flow return on investment (CFROI) to determine whether a company creates value for shareholders and if the shares are attractively valued. On this basis, both UK and French small cap stocks currently look slightly cheaper than their larger peers, although historically this has nearly always been the case (except for a short period just over a year ago). This lower valuation would normally attract the attention of private equity firms, but is less likely in the current climate of reduced liquidity in the banking system. As a result, we may need to be more patient than usual for value to be realised. In the meantime, management can play their part by maximising long-term cash flows and, where appropriate, returning cash to shareholders via dividends.

JC: As Graham notes the UK small cap sector is now rated in-line with the wider market. While that’s a big change from the premium they have enjoyed in the past 3 years it’s not especially cheap by historic standards.

Unfortunately I can see few catalysts to drive a re-rating in the short term. Many small cap funds are facing redemptions – driving prices lower – and there is little scope for private equity activity given the lack of available debt funding. However we view the current firesale prices available on many solid companies as offering fantastic opportunities for the long term investor – but don’t expect to make massive profits overnight!

.....................................................................................................................

Why do small UK based companies find it so difficult to attract research cover beyond their corporate broker and is there any sign that in house research by fund managers will offset this in their decision making process. Likewise, what value is put on paid for research?
Alan Bulmer, Exeter

GA: Despite new EU directives such as MIFID encouraging the splitting of commission payments between research and execution, the amount of research carried out on a company is often simply down to economics. If a company is quite small and there is not much turnover in the shares, many sell-side firms will judge that there will be insufficient commission to justify carrying out detailed research. This is particularly the case where there is no existing or prospective corporate relationship.

However, this can often be an advantage for investors prepared to carry out their own analysis as there is a greater probability that the shares are mispriced. To help us, we use some very useful screening tools such as Credit Suisse’s HOLT and Collins Stewart’s Quest to analyse and value companies.

JC: Small cap companies attract little research cover because they generate little commission for brokers who make their money trading shares for their institutional clients. There is little incentive for brokers to spend time unearthing profitable investment opportunities for their clients if this produces little in the way of compensation.

However investors should rejoice at this fact as it leads to an imperfect, inefficient market where a dedicated stockpicker can consistently generate market beating returns. When I hear a company – which I know is doing all the right things – bemoan the lack of research coverage it receives or the fact no analyst is interested, I get very excited. It often means the market is missing a great investment opportunity. In contrast, it’s very difficult to get a new angle on a company which is covered by 30 analysts who are poring over every detail. Small cap stocks are often only covered by one or two analysts who are often busy covering another 30-40 companies as well.

I believe that paid-for research has a valuable role in the market – especially with illiquid companies which attract little broker attention. However, always remember that “he who pays the piper calls the tune”, and this is as true for independent research as with that produced by a company’s own housebroker.

.....................................................................................................................

If the US does slide into recession how much have UK small caps left to fall or have they bottomed out?
Breffni Potter

GA: Regardless of whether we tip into a recession, the economic outlook in both the US and the UK looks the most difficult it has been for some time. As a result, we are focusing our attention on companies with strong business models and balance sheets. We strongly believe that valuations of UK small caps are now at attractive levels, but equity markets are notoriously unpredictable in the short-term and it’s entirely possible that they could get even cheaper!

JC: The UK small cap sector is far more domestically focused than the wider FTSE All-Share so it’s more important to look at the outlook for the UK economy rather than the US. I believe that the UK market in small caps has moved fast to discount quite a severe downturn. The speed of this discounting might be explained by more “hot” money being in the sector – hedge funds, for example – than was the case in previous cycles. The sell off has also been exaggerated by a wave of redemptions from small cap funds. Personally I expect a slowdown in the UK economy but not as steep a downturn as that evident in the US. Given the savage derating in small caps, a lot of bad news is already in the price. As Graham notes, we favour companies with strong balance sheets and reasonably defensive earnings streams.

.....................................................................................................................

Do you factor in a certain discount in valuing small-caps for their perceived lack of liquidity?
SK New, Hong Kong

GA: Although we closely monitor liquidity, we like to take a longer-term approach to equity investment. As a result, we do not apply a small cap discount.

JC. A lot of fund managers get very hung up on the lack of liquidity in small caps. But, in my view, you should not worry too much about this issue. My views are probably best summed up by Peter Lynch (manager of the Magellan fund in the US) who once said: “In stocks, as in romance, ease of divorce is not a sound basis for commitment. If you’ve chosen wisely to begin with, you won’t want a divorce – and if you haven’t, you’re in a mess no matter what.”

.....................................................................................................................

There are small caps which are trading at very low multiples to their earnings and net assets, and yet their share prices hardly move in years. How do you avoid these ‘value traps’?
Vincent Tan, Malaysia

GA: We seek to avoid these ’value traps’ by investing in companies with robust business models and balance sheets that can continue to grow throughout the economic cycle. My experience is that stocks with high dividend yields but no dividend growth typically underperform, regardless of their size.

JC: The best way to avoid such value traps is too invest in a business which has a strong franchise that will generate growing profits. In these instances at some stage the price will catch up with the growth in earnings or the P/E will go to zero! However it’s certainly true that many fund managers avoid value traps by looking for catalysts which will excite investor’s interest over the next 6-12 months. This could be a new product or service, expansion into new markets or even some form of financial restructuring. Anything that is likely to bring the undervaluation to the investment community.

But my basic view is that if all’s well with the company and whatever attracted you in the first place hasn’t changed then sooner or later your patience will be rewarded.

.....................................................................................................................

I have taken a punt on two highly illiquid stocks which are due to report at the end of the month.They are Mercury Group PLC and MobilityOne Ltd and one of the reasons that I have chosen them is that they both seem to be invisible to the press. Please could you let me know what you think of my stock selection and my strategy?
Ralph William Gunn, London

GA: Your stock selection strategy is an interesting one, but not without considerable risk. For most investors, it would be preferable to invest in a pooled small cap fund or a selection of stocks which have a proven track record in creating value for shareholders.

JC: The fact you describe yourself as “having taken a punt” suggests an approach more akin to gambling than investing. Having looked at the two stocks in question it’s clear you have invested in the very high risk “micro” cap area of the market. I would only advocate investments in this arena if you have some specialist knowledge of the companies in question. I’m biased, of course, but when it comes to investing in the small cap arena I would favour choosing a pooled fund with a proven track record.

.....................................................................................................................

There are dozens of resources companies on Aim. Which indicators can I use to pick the next Cairn Energy?
Hugh Cloughton, Wales

GA: Investors should be aware that many companies choose to list on AIM as they don’t need to have as long a track record as to obtain a listing on the full market. This also means that the AIM market is likely to attract more than its fair share of ‘hot’ companies in a ‘hot’ market, such as we have seen in commodities in recent years. As a result, my advice would be to proceed with caution.

JC: Though AIM does have some excellent companies this index does tend to attract some high risk propositions because of the limited track record required for a listing. This is especially the case in recent years with many companies from the ‘hot’ commodities sector listing. Like Graham I would proceed with caution and focus on companies with a proven track record.

AIM’s long term rack record is unfortunately quite poor. From the end of 1996 to the end of 2007 the index returned only 0.3 per cent per annum. In contrast the Hoare Govett Smaller Companies returned 9.1 per cent per annum in the same period.

.....................................................................................................................

What is the difference in the impact on price from the small cap to medium or large cap stocks as a result of the credit crunch conditions we are seeing? Are the key indicators of recovery felt any differently in the small cap sector?
Nick McArdle, London

GA: Large companies are generally viewed as having stronger balance sheets than their smaller peers although, as we have seen from events over the past few days at Bear Stearns, this is not always the case. However, it is fair to say that small and medium-sized companies generally require more capital to expand than their larger peers and are therefore more dependent in the longer-term on the capital markets functioning with sufficient liquidity. This is one of the key reasons why small-cap stocks underperformed in the second half of last year, although there are many companies across the market spectrum that currently have strong balance sheets and should be able to get through current market difficulties without too much of a problem.

JC: I think it’s a myth that small cap stocks are always riskier than their large cap peers – just look at what’s happening to the (large cap) banking sector in the developed world. Importantly, small cap companies often have large directors’ shareholdings – this means they don’t suffer the agency problems prevalent in large caps. Maybe if some of the directors of the banks owned 10-20 per cent of the equity (not uncommon in small caps) they would have kept a closer eye on the loan book!

As to the current credit crunch the in the UK, the small cap sector does not appear to have been particularly hard hit on a company specific level. Sure, small companies with high levels of debt are being sold off heavily but that’s a feature of the large cap sector as well. The main problem is that small cap shares are seen as higher risk and there is huge risk aversion in the current market. As soon as investors become less risk averse (evident from factors such as government bonds falling in value) small cap stocks should rally.

.....................................................................................................................

We constantly read about the need for renewable energy, biofuels and clean emissions technology. Yet very few of the UK-based small caps in these sectors are performing. Can you explain why?
Peter Whiteman, Leeds

GA: Just because it’s written about in the press, it doesn’t mean that they’re necessarily good companies or good investments! Like any new area, there is plenty of potential but very few companies are able to capture all of this upside as competition is often fierce.

JC: I’m not an expert on this space but investors should note that companies operating in these sectors are perceived as high risk (few make profits). As a result they are likely to be sold off as investors flee assets perceived as higher risk.

.....................................................................................................................

How useful is AIM as a market when in the current scenario it is obvioulsy unable to reflect the inherent value of a small cap company. It seems as if all small caps are being valued with one single indifferent pricing mechanism?
Nadeem Sheikh, London

JC: I believe the AIM market is still very useful as a means of raising capital for small companies with a short track record. However it is currently suffering from the general risk aversion prevalent in the market place (it is perceived - rightly or wrongly - as high risk). As risk tolerance increases we would expect the valuation of companies listed on the index to recover.

I do not, however, think that all AIM stocks are being indiscriminately marked down. At CSAM we have substantial shareholdings in several AIM companies such as Synergy Healthcare, ASOS and Lamprell. None of these comnpanies appear to be suffering particularly badly from being AIM listed stocks.

GA: Exactly. There are some real gems within AIM, but you need to do your homework and accept some increased volatility in current market conditions.

.....................................................................................................................

Pan-European small caps and value investment styles tend to underperform large cap-growth stocks when volatility rises as investors get more risk-averse. On the other hand, defensive growth styles have a strong tendency to outperform small caps as volatility increases. How long will this continue?
Nooraldeen Barazanji, Abu Dhabi

GA: We look at three key factors which, when combined, have provided a list of stocks which have outperformed over the economic cycle: Quality/Operational Performance, Value and Momentum. In 2007, Quality/Operational Performance and Momentum performed well, but Value did not – particularly in the latter half of the year as stock market volatility significantly increased. However, despite the setback in equity markets, this partly reversed in January – with Value outperforming the other two key factors. In addition, UK small cap stocks outperformed their larger peers in February, so it’s often too simplistic to take a top-down view of which parts of the equity market will outperform.

JC: In the last 12 months the market has aggressively sold off leverage and cyclicality – not just in small caps but in the large cap arena as well. Companies with strong balance sheets and perceived defensive earnings streams have fared much better. However investors in the small cap sector have faced additional problems from many investors aggressively reducing their asset allocations to the small cap space. If investors become less risk averse and more confident on the economic outlook there should be a huge bounce in the more cyclical and indebted small caps (which have been aggressively sold off) – but I would not expect such as scenario until the third quarter at the earliest.

.....................................................................................................................