Blue Chip Issue 90

BLUE
CHIP
INVESTMENT | Economy
Could smaller companies
have a bright spot despite
a gloomy environment?
Investing in smaller capitalisation (small cap) stocks when
economic conditions are tough can feel uncomfortable. Yet,
history tells us that this can be a good time to start considering
whether these companies deserve a place within a diversified
portfolio. We analysed data from the past five decades to get some
insights from history to test this thought.
The stock market gazes into the crystal ball
One of the best leading indicators is the stock market itself. This is
because investors are not only concerned with today’s headlines but
also how the future will unfold. Investors anticipate how the future
might unfold and then transact in company shares accordingly,
driving the share price up or down in advance of actual news. This
means – for example – when a company announces how much it
has grown its sales by, the share price might not change on that
day if the company grew by the amount that investors expected.
What tends to send the share price moving on the day is when
the announcement is above or below what was expected. Small-cap
stocks are no different in this way, and this can be a clue to guide
us to what may be in store for their future.
What the market expects
Over the past year, the fortunes of large and small companies
worldwide have diverged. This was primarily driven by the largest,
so-called magnificent seven companies in the US, but also reflects
the risks associated with owning smaller companies, which are
more sensitive to the economic cycle.
One-year cumulative return for global large vs small
companies (USD)
Investors may favour larger companies in the late phase of an
investment cycle for a few reasons. Larger companies have multiple
research analysts interpreting their performance which reduces
uncertainty, they have easier access to finance in times of need and
they have multiple diversified products to sell which helps stabilise
their cash flows. This makes larger companies an attractive offering
going into an economic slowdown. But as the above performance
chart shows, this may have already been acknowledged by the
market. The key question is whether small-cap stocks may have
enough “bad expectations” in their price; we could look to history
to guide us.
Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them
may go down as well as up and investors may not get back the amounts originally invested.
54 www.bluechipdigital.co.za