Now is the time for investors to start buying small cap companies. For most of the 1990s, investors have not been well served by owning equities in the group we call small cap (generally defined as companies with market capitalization under $800 million).
While pundits and investment mangers have many theories as to why this is the case, history provides the greatest insight and the strongest case for why now is the time to invest.
Small cap companies under-performed large caps for extended periods in the 1950s, late 1960s and early 1970s. The common thread through these periods is a slowing economy after a period of strong economic growth.
In prosperous times, the shares of large, well-known corporations soar and these companies account for a disproportionate weighting of the stock markets.
In the 1970s, it was the Nifty Fifty, where companies like Xerox and McDonald’s dominated. In the 1990s, Tech companies like Cisco and Nortel rose to the top. During an economic boom, it is the large companies that do best. Large companies are able to grow revenue with the general economy, using excess capacity to improve margins and earnings.
Although all companies benefit from good times, nimble small cap companies generally grow by either constructing new facilities or entering niche markets that larger players aren’t agile enough to exploit. This kind of growth is less sensitive to the economy and, as a result, holds up in slower economic times.
We see history repeating itself. Until this year, market watchers saw no end to good economic times. Then came March and a major market correction. Investors started to question their beliefs. It is also no coincidence that in the U.S., small to mid-cap companies started to outperform large caps at the same time.
The same cannot be said in Canada because of Nortel: one outperforming stock that represented about 30 per cent of the TSE 300. Recent events have hit Nortel hard and may be bringing the TSE more in line with markets south of the border.
This is in no way saying that Nortel or other large tech stocks are not great companies. Rather, at this point in the economic cycle, small companies that are not trying to double $30 billion in revenue, like Nortel is attempting, might be more attractive investments.
The next question is what names investors should look to. If you agree that the cycle has finally turned, the first place to buy small cap companies is in sectors where large cap companies have outperformed. Names like Canadian Western Bank, rather than Bank of Montreal, Sleeman’s rather than Molson’s and so on.
If there has been good reason to own the larger names, and there has been, then the same applies to their high-quality, smaller rivals.
Dissatisfaction with Big Banks has opened up the door for smaller, customer-oriented niche players. A company like Sleeman’s is capitalizing on the entry of the Baby Boomers’ children into the age of majority and the consolidation of small, craft breweries.
As with any investment strategy, it is important to evaluate your own risk and return profile before making any investment decision. Generally, small cap companies offer higher risk levels along with higher returns.
If we can learn anything from history, small caps have their proper — and sometimes lucrative — place in an investment portfolio right now.
Evan Spiropoulos is a portfolio manager of the Norrep Fund, a public small cap fund managed by Hesperian Capital Management.
