It was not supposed to be this way. Back in January, one of the most confident predictions was that small-cap stocks’ run of out-performance was about to end. That call looked good after smaller companies came off worst during the short, sharp shock administered to world markets in May.
But the most recent leg of the equity market rally has been led by smaller stocks, on both sides of the Atlantic. In the US, the Russell 2000 index of smaller companies is up 19.4 per cent for the year – easily beating the Russell 1000 index of larger companies, which is up 14.8 per cent.
In the UK, the FTSE Small-Cap index has returned 2 per cent over the past month, while the FTSE 100 has slipped 0.6 per cent. For the year, it has gained 12.2 per cent, against only 8.3 per cent for the FTSE 100. In Europe, the FTSE Eurobloc index for larger companies is up 27.7 per cent for the year, in dollar terms – but smaller companies have gained 41 per cent.
Small companies have easily beaten large caps ever since the internet bubble burst in 2000. Over the past five years, the FTSE 100 has averaged an annual return of 6.9 per cent; the Small-Cap index has returned 10.4 per cent. In the same period, the Russell 2000 has grown at 12.6 per cent per year, almost twice the Russell 1000’s growth of 6.8 per cent.
The reasons why small-caps should go off the boil look good. They are more sensitive to interest rates than large companies and more vulnerable to recessions, as they do not have brands and diversification to sustain cash flows in tough times. They do not offer large caps’ play on globalisation, which is where the money is. They are not cheap, with a dividend yield of 1.0 per cent, against 1.8 per cent for large caps, according to JPMorgan. And, they are riskier.
One factor in their favour; smaller companies are easier to buy out, so they benefit more from the wave of private equity deals. Beyond that, it looks like their advance is due to the equity market’s growing conviction that the US economy is in for a “soft landing” and an appetite for risk that is not currently shared in the treasury bond or forex markets.
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