As interest rates have declined in North America, small-cap stock performance has responded favorably.
By definition, small-cap companies that trade on a public exchange have market capitalizations, that is stock price multiplied by shares outstanding, of less than $500 million in Canada and $1 billion in the United States.
Historically, small cap companies tend to outperform large caps by an average of three percentage points on a quarterly basis after the type of economic slowdown we’ve seen recently.
One reason is that smaller-cap companies tend to return to earnings growth much faster than their large-cap cousins do.
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We might already be six to nine months into the superior performance period, which normally lasts 12-15 months. After that, returns slow, although continuing the rising trend for almost three years.
Evidence of the trend can be seen in the Canadian Small Cap Index outperforming the broader market, increasing almost 12 percent for the first six months of the year, while the Toronto Stock Exchange total return index is off 13 percent over the same period.
Given the huge amount of economic data being released and the good potential for a return to earnings growth in 2002, the environment might be right to build up the small-cap exposure within portfolios.
Investors should focus on companies that have sound business models, diversified revenue bases, a leadership or niche market position, strong earnings growth and clean balance sheets.
Also, companies that use their cash flow to grow during slow periods should be considered as more defensive positions.
Buyers should know the people who run the company and whether their entrepreneurial vision is striking a balance with capable management.
It may be early to make a full gamble, but investors should start slowly picking up some of the companies that also have more of a cyclical slant to them, if one believes that the economy in 2002 will be better than in 2001.
One sector that is holding up is building materials. New home construction is still exceeding expectations in the U.S. Also, as mortgages are refinanced, the potential for greater renovation spending exists.
Given these factors, the building sector shows signs of promise.
Some Canadian small-cap companies offering exposure to this sector are Richelieu-Hardware and MAAX.
In the furniture sector, expect continued softness in the near-term, but longer-term improvement.
An example of one company that should outperform its competition this year is Shermag, although it will continue to trade at a discount to its U.S. competitors until profit margins improve.
If holding small-cap company stock directly isn’t your cup of tea, there are a few recognized small-cap mutual funds providing a more diversified bang for your buck.
The Fidelity Small-Cap America fund provides exposure to American small-cap companies and has returned 18.3 percent since inception in April 1994.
In Canada, the Trimark Canadian Small Companies fund provides exposure to Canadian small-cap companies and has returned 13.3 percent since inception in May 1998.
Ian Morrison is a financial consultant with CIBC Wood Gundy in Calgary and is licensed to sell insurance products.
He can be reached at 800-332-1407 or by e-mail at Ian.Morrison@cibc.ca. His views do not necessarily reflect those of CIBC World Markets Inc. This article is for the information of investors only and does not constitute an offer to sell or solicitation to buy any securities referred to herein.
