Mid Caps and Small Caps Steal the March!

• In the UK, the FTSE SmallCap index has lagged the FTSE 250 but, as the chart shows, both indices have outperformed the FTSE 100 by a considerable margin. In the US and the Eurozone, the small caps have outperformed the mid caps and the mid caps have outperformed the large caps. In Japan, both the small caps and the mid caps have outperformed the large caps.

• While the 1990s belonged to the large caps, this decade thus far belongs to the smaller companies. Maybe the ‘size effect’ has returned in the new millennium. This is the phenomenon in which smaller firms, as measured by their market capitalization, generate higher average rates of return than larger firms, even after adjusting for risk.

• Much has been made of the influence of mergers and acquisitions on the performance of the mid caps but takeovers have been widespread and the large caps have seen their share of it.

• However, to focus on corporate activity is to miss a fundamental point. The fact is that the growth in corporate profitability during the past four years has been unusually and surprisingly strong. This, along with low and broadly stable long term interest rates, has helped to create the environment in which mergers and acquisitions have thrived. Indeed, without this fundamental backdrop, it is doubtful that the takeover scene would have been anything like it has.
  

• By focusing on the merger mania one can lose sight of the historical trends, which show broadly that, when the good times roll, as they have been doing for the global economy, the shares of smaller companies do well in comparison to the shares of larger companies.

• The chart below shows the annual percentage change in the UK Hoare Govett Smaller Companies Index relative to the FTSE All Share Index - referred to in the chart as the price relative for smaller companies - and the annual percentage change in real GDP for the big economies, used here as a proxy for the global business cycle.

• The correlation between the two is far from perfect but during the 1970s, the early 1980s and, more recently, since the turn of the new millennium, the price relative for smaller companies and the business cycle have been in phase. For the most part, the price relative has led the cycle but on occasion lagged it and, more recently, has been coincident with it.

• As the chart also shows, the two trends were well out of phase between the late 1980s and the late 1990s, when the small caps - and the mid caps too - underperformed the large caps. Nevertheless, there is a relationship between the price relative and the business cycle that is still apparent.

• Overall, the impression is that the cycle has mattered. The relative fortune of smaller companies appears to have been tied to the swings and roundabouts of the cycle with the shares outperforming during the upswings - the good times - and underperforming during the downswings.

• Until a shock or monetary policy brings the current expansion to an end, there is reason to expect the large caps to continue underperforming, although they will have their days or brief periods when they do relatively well.

• What can we say about a shock? Nothing, other than when it comes, it will come as a surprise. As for monetary policy, we feel that the risks are on the upside for interest rates. This is only because we think there is still plenty of momentum in the global economy (see 2007 – A Year of Grinding Onwards! 7^th December 2006) and that the risks for inflation are on the upside.

• If you are of a cheerful or optimistic disposition and reckon that the outlook for economic growth, corporate profitability and the equity markets is still ‘okay’, the message is to remain positive on the outlook for the mid caps and the small caps. In the UK, the chances are that the FTSE 250 and the FTSE SmallCap indices will continue to outperform the FTSE 100. That is despite valuations which favour the leaders.

* The information contained in this report has been taken from public sources and is believed to be reliable and accurate, but without further investigation cannot be warranted as to accuracy or completeness. The opinions expressed in this document are not necessarily the views held throughout Brewin Dolphin Securities Ltd. No Director, representative or employee of Brewin Dolphin Securities Ltd. accepts liability for any direct or consequential loss arising from the use of this document or its contents. We or a connected person may have positions in or options on the securities mentioned herein or may buy, sell or offer to make a purchases or sale of such securities from time to time. In addition we reserve the right to act as a principal or as agent with regard to the sale or purchase of any security mentioned in this document. Prices, values or income may fall against the investor’s interests. You should therefore be aware that you may get less back than you invested. Past performance is not necessarily a guide to future performance. If you are in any doubt concerning the suitability of these investments for your portfolio, you should seek the advice of a qualified investment adviser.