Small caps are predicted to outperform again

AFTER being decimated during the financial crisis of 2008, smaller cap companies enjoyed an outstanding 2009 according to RBS’s Hoare Govett Smaller Companies (HGSC) index. The index, which consists of the bottom tenth by value of listed UK equities not including the Alternative Investment Market (Aim), recorded an absolute performance of 54.2 per cent. This was the best annual performance since 1977 and it outperformed the FTSE All Share by 24.1 per cent. The version that includes AIM stocks – the HGSC plus Aim index – achieved a return of 55.6 per cent.

This extraordinary performance was partly because of how badly small companies were hit by the crisis. Professors Elroy Dimson and Paul Marsh of London Business School, who produced the index, predicted last year that stocks which had been most affected by the crisis would do best in a recovery. This proved to be the case: after proving resilient during the poor first quarter of 2009, they made substantial advances during the bounceback.

However, while 2009 was a good year for small caps, you needed positions in the right sectors to make strong gains. The HGSC index breakdown shows that the three best performing sectors relative to the FTSE All-Share in 2009 were industrial metals mining technology hardware and other metals mining. Alternative energy and non-life insurance were the worst.

Good news for contracts for difference (CFDs) traders looking at minnow stocks this year – small and mid-sized companies should continue to do well. Stephen Ford, head of UK mid-market equities at RBS, says: “A period of consolidation is expected in the short-term. However, restructuring benefits coupled with robust balance sheets and top line appreciation should underpin earnings upgrades and further outperformance.”

Thanks to the enduring emerging markets growth story and China’s voracious appetite for materials, mining and basic resources should enjoy good returns throughout 2010. A rebound in the oil price has been beneficial to smaller exploration stocks such as the Falklands four (Desire Petroleum, Rockhopper Exploration, Borders & Southern and Falklands Oil & Gas) which are exploring potential fields in the Antarctic Ocean.

But while it is worth researching stocks with potential for a big surge (mining and biotech firms often see price spikes following resource finds and drug approvals), be careful not to jump on the back of a spike.

Andrew Sykes, a financial sales trader at Spreadex, warns: “People often buy stocks after they have had a big move. This is not unique to small caps but it is much harder to get out of them when it does happen.”

Regulatory issues are seen as a big impediment to liquidity in smaller stocks. Although CFD traders do not hold physical shares, they need to realise that low liquidity makes the stock prone to price gaps.

Smaller stocks won’t repeat their stellar 2009 performance, but there is still upside for many companies – it’s just a case of picking the right ones.