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Appetite for small-cap stocks has waned since the onset of the credit squeeze amid resurgent demand for blue chips, with the FTSE 100 outperforming the FTSE SmallCap Index this year for the first time since 2002.

Small-to-mid caps traditionally outperform in a rising market, while turbulence drives equity investors towards the companies with the strongest fundamentals and most reliable returns. Jim McCafferty, head of research at Seymour Pierce, argues that ”in periods of stock market weakness, investors will turn to the safest stocks”.

But is there still value to be found in small-cap stocks? Mr McCafferty answer your questions on smaller stocks and the relative attraction of small-cap companies.

Is the world economy heading for recession in 2008? Central banks like the US Federal Reserve can cut rates to avoid a recession. Will this help the economy in the longer terms. And how will such a move affect small-cap stocks?
Nilesh Parekh, London

Jim McCafferty:Small cap stocks tend to be more exposed to the domestic economy than their bigger, more international peers. Rate cuts tend to stimulate consumer spending and encourage investment. Lower rates also reduce interest charges which implies upgrades to earnings. Both of these factors are helpful for equities.

Which smaller stock sectors are hot right now?
Bernd Reichel, Irving, Texas

Jim McCafferty: The growth rates coming from the Chinese and Indian economies are driving up the prices of commodities. For this reason, energy production companies are in vogue. Renewable energy companies have the environmental angle which investors are keen to harness.

I read today in a book about investing in ETFs that small caps or large caps have historically been in favour for periods of around five years. I’d be interested to know your views on this. Also, what rule-of-thumb tips can you provide when choosing among small-cap growth/small-cap value and large-cap growth/large-cap value?
Gordon Graham, Taipei

Jim McCafferty: The UK small cap index has more than doubled in the past five years and has outperformed the main market. This has led to a valuation premium being attached to it. Small cap firms are trading at 24 times earnings. Shares in FTSE 100 companies are trading on a PE of 12 to 13. this probably suggests that the small cap index is now more vulnerable.

I think ETFs are probably more appropriate for big cap indices where stocks are liquid and well-researched. Bottom up stock selection pays dividends in the small cap arena as information is less perfect. In terms of screening, I would suggest that backing the small cap dividend payers would be a good method of reducing risk. We have composed a Seymour Pierce Aim Dividend payer index. This has consistently outperformed the market.

Is there a particular area of the small-caps universe that you are focusing on right now? Some suggest value plays with strong balance sheets to weather the credit crisis while others prefer strong growth companies that maybe more immune to a general economic slowdown. What is your position?
Clement Loh, Toronto

Jim McCafferty: I have studied the balance sheets of Aim’s biggest constituents and have identified that they are in very strong shape. This is partly because there has been much secondary fund raising in the first half of 2007. Smaller companies, including those listed on Aim do not have as much access to the debt markets as their larger peer group.

Our calculations show that Aim companies are sitting, on average, on a net cash position. This should insulate them from rate hikes. We prefer those companies which are profitable and pay dividends. The latter is a good discipline which is shareholder friendly.

Is Alistair Darling’s move to scrap taper relief for unquoted companies bad news for Aim-listed companies?
Gary Daniel, London

Jim McCafferty: Undoubtedly the initiative to scrap taper relief is bad news for many Aim companies. However, Aim companies still qualify for other tax benefits such as IHT relief. Darling’s initiative is coupled with a move to reduce CGT across the board which should be good news for equity markets in general.

Where is the best place to I find ratings of small-cap companies on the internet?
Kevin Fox, New York

Jim McCafferty: Hemscott publishes an earnings guide for all UK stocks. This can be accessed online.

My broker says financially healthy well run small-caps are hard to find. How do I screen for blue-chip like small-caps?
Clive Boulton, San Mateo, US

Jim McCafferty: When screening for stocks a good rule of thumb is to look for those which pay dividends. If you see a five year track record of growing dividends, then this is a good sign.

Do you think that the conservative approach will prevail among investors and lead to the small-cap stocks’ de-capitalisation in time of high volatility in global capital markets?
Viktor O. Ledenyov, Ukraine

In uncertain times there is a general flight to safety and quality. However, recent events both in the UK and the US show that financial scandal can occur in big cap stocks as well. Enron and WorldCom are good examples. The recent demise of Northern Rock is testament to demonstrating that there is much risk in big cap stocks too.

Aim has been a great success, but there are now hundreds of low-cap (10m or less) businesses with a difficult future as public companies. How will the market sort the problem: the cost of bids and delisting are so high. Shouldn’t many never have floated? Did Aim brokers act irresponsibly to float so many businesses?
John Yeomans

Jim McCafferty: M&A activity will filter down into the smaller companies on Aim and remove companies which should not be listed. Many companies on Aim are unsuitable for institutional investors, but the necessity to have a very small free float allows companies to be listed without a professional investor shareholder register. It is likely that the private equity industry will identify these candidates and buy out shareholders.

The LSE’s efforts to reduce the number of Nomads will help alleviate the problem of too many unsuitable companies being on the market. Brokers are simply the medium for a public listing. They put their firms reputation on the line by sponsoring deals. Investors should know that Aim companies carry a health warning.

How can you tell if a small-cap company will go first tier? What should investors focus on when picking a small cap company?
Yuen, Canada

Jim McCafferty: It is always useful to look at a company’s five-year track record. If a company has shown little growth, the chances are it is unlikely to grow in the next five years. If, however, a company has seen strong growth in terms of revenue and profit in the last five years, the chances are that it might continue to do so. Investors should look for strong management. Dividends are also an indicator of a shareholder-friendly management team.

Small-caps historically have underperformed in periods of high inflation, weak dollar, and periods of uncertainty (political, economics, monetary policy, inflationary outlook, reversion to the mean of profitability etc). Do you see these factors to be impacting the prospects of small-cap stocks for extended periods of time? In addition, do so you see pockets of opportunity around the world despite some of the headwinds faced by small cap stocks?
Arun Bharath, Marina del Rey, CA

Jim McCafferty: I reckon that UK small-caps are more insulated from the weak US dollar than companies in the big-cap indices. This is because UK small-caps are less international than their bigger peers and rely less on overseas markets. Investors are more likely to find domestic businesses in the small cap index than in, say, the mid 250 or the FTSE 100.

Equities, in general, can be a useful inflation hedge. Small-cap investors need to do their homework and a bottom-up stock selection process is essential in order to make returns in this market. Pockets of opportunity lie in areas such as biofuels and natural resources.

About the expert

Mr McCafferty is head of research at Seymour Pierce, the broker. He publishes regular commentary on all aspects of the Aim market together with thematic research on UK equities. He started his City career as a graduate trainee at County NatWest in 1991. He has been a highly rated telecoms analyst at ABN Amro and Societe Generale where he was Head of European Telecoms Research.

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