Will small-cap boom turn into gloom?
29 September 2003
Singapore small-cap stocks have done extremely well so far this year. While the Straits Times Index (STI) has risen by 21 percent since the beginning of the year, the UOB Sesdaq index has risen by a whopping 110 percent.
Small-caps are essentially cyclical plays. Their small size and lack of diversification make these companies vulnerable to economic downturns. And coupled with the lack of liquidity in the market for their shares, they had been badly battered during the bear market of the last few years.
Now, however, with signs of the global economy recovering, investors are betting that the earnings of small-cap stocks will rebound and are pouring money into these counters. The lack of liquidity in their shares now work the other way, causing their share prices to surge with the influx of investor money.
Therein lies the risk in investing in small-caps – they are highly volatile. And their periods of outperformance tend to be short-lived. Bouts of heart-stopping outperformance have usually been followed by wrenching underperformance.
For example, in 1994, the UOB Sesdaq index peaked at 156.95 on 4 January. In the preceding 12 months, the index rose 187 percent, outperforming the STI by 128 percentage points. In the following 12 months, the index fell by half, underperforming the STI by 40 percentage points.
In 1997, the Sesdaq peaked at 131.59 on 25 July. In the preceding 12 months, the index rose 65 percent, outperforming the STI by 72 percentage points. In the following 12 months, the index fell 66 percent, underperforming the STI by 20 percentage points.
Finally, in 1999, the Sesdaq peaked at 203.6 on 2 July. In the preceding 12 months, the index rose 327 percent, outperforming the STI by 230 percentage points. In the following 12 months, the index fell 46 percent, underperforming the STI by 38 percentage points.
Furthermore, small-cap stocks tend to do best when earnings are accelerating. While the global economy appears to be recovering, the sustainability of the recovery remains uncertain. Many analysts actually think that the earnings cycle is already peaking, that is, year-on-year earnings growth rates are likely to slow down soon. Once that happens, investor focus may shift from earnings momentum to earnings quality. That usually means blue chips, not small caps.
So will the small-cap boom turn into gloom for investors? It is hard to say for sure. Excesses can persist for a considerable period of time, as with the technology bubble of the late 1990s. And if the economic recovery proves stronger than expected, current valuations of small-caps may even prove to be justified.
But downside risks have clearly risen. Investors who are still keen on playing in the small-cap arena should stay alert and nimble.
Disclaimer: The commentaries posted here represent the opinions of the author at the time of posting and should not be taken as investment advice. Readers who wish to take any investment action based on information obtained from this site should seek appropriate advice from a qualified financial adviser.