Historically, large or small capitalisation outperformance runs in market cycles.
In the US, for the last five and a half years, small cap stocks have returned 12.6 per cent per annum versus the paltry -0.7 per cent per annum of their large cap counterparts. In Europe and the UK, over the last three years, small caps have outperformed their larger brethren by 47 per cent and 22 per cent respectively.
It has not always been a small cap investment party. Six years previously we saw large caps dominate investment returns. In fact, from 1994-1999, US large caps returned 23.9 per cent per annum versus 11.8 per cent per annum for small caps.
As they say, what goes up, must come down. Periods of large cap out-performance typically is followed by small cap out-performance and vice versa.
Small caps typically outperform coming out of a recession and into a strong growth environment, when there is a greater exposure to consumer spending and rising housing prices.
In the current environment, the US Fed continues to tighten and cool the housing market’s escalating price inflation while tightening the banking sector’s lending standards. Real estate appears to be peaking, as interest rates continue to rise, homes are taking longer to sell and lumber prices have fallen 30 per cent in the last five months.
In the UK and Australia, for example, once the housing market peaked, consumer confidence and retail sales rolled over. In the US, consumers have continued to overspend because of the enormous wealth effect of the rising housing market. However, soaring gas prices and the cooling of housing price inflation will have a detrimental impact on consumer spending that will be felt hard in the economically sensitive small cap asset class.
Small caps are trading at near historical premiums to large caps, and are under pressure as overall corporate margins narrow, and are extremely vulnerable to even modest disappointment.
In a slowing economic environment, and especially when equity markets are weaker, large caps offer better returns and are more diversified, serving multiple markets and regions.
Currently, US small caps are trading at a 15.7 per cent premium to large caps and are forecast to have zero growth in earnings in 2005 versus 19 per cent for large caps. In the UK, small caps are now trading at a 15.6 per cent premium to large caps on 2005 earnings, and are expected to see earnings growth of just 4.3 per cent compared with 7.5 per cent for large caps. European small caps have 2005 forward estimates of zero earnings growth contrasted with large caps at 8.5 per cent.
The party is not over for just large versus small. Many market participants believe after 54 months of value outperforming, the time is right to move exposure into growth stocks. The excess valuations of the late 1990s have been more than corrected and the actual costs of stock options are soon to be expensed across all companies.
Quality companies with strong growth characteristics and high cash flow return on investments can be bought today at valuations comparable to those of average companies. Microsoft, a high quality, growth company, is launching an unprecedented rollout of products: X-box, a new Office suite, and its new operating system (Longhorn) within the next 18 months. Yet the stock trades at a 48 per cent discount to its 10 year average with 12 per cent long-term growth rate.
According to Morgan Stanley Research, S&P 500 Growth relative to S&P 500 Value, value stocks have outperformed since 2000, but growth stocks outperformed from 1994-1999. This pattern of outperformance has followed the same pattern of small cap outperformance versus large cap and vice versa in the US. The small cap and value style investing has performed best over the last six years, but who knows what is going to happen in the future? No one style of investing appears to consistently stand out over different economic cycles. The risk of betting on the wrong style is too great.
Our view – large cap growth looks cheap and small cap and value looks expensive after a six year run. We see 2005 continue to grow above trend, but 2006 will see a slowing in the global economy in the second half of the year.
It’s time to re-evaluate your weightings to global large cap growth stocks to ensure a more diversified investment return.
As growth becomes scarcer for value and small cap stocks, as oil prices reach over $60 a barrel, in a rising interest rate environment, with a consumer spending slowdown and a decelerating global growth, quality growth stocks could be poised for a rebound similar to 1993 and 1994 – the last bull market for growth stocks.
