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Table of Contents
Put your financial adviser on a leash
February 11, 2000
100% Foreign content for your RSP
December 22, 1999
Tax Loss Selling or Dealing With Your Mistakes
November 26, 1999
Life Stages of your RRSPs
November 12, 1999
Just give me boring (but great) rates of return
November 3, 1999
De-mystifying Demutualization - part Two
October 25, 1999
De-mystifying Demutualization - part One
October 19, 1999
Seg funds for the simple minded
September 14, 1999
The interest rate game Part 2
August 12, 1999
The interest rate game Part 1
July 30, 1999
Choosing funds: Five for the long run
July 14, 1999
New Funds: To buy or not to buy
July 2, 1999
Making sense of momentum investing
June 18, 1999
Rating the fund managers
June 4, 1999
Resource recovery hinges on supply and demand
April 30, 1999
Tech funds draw strength from favourable trends
March 24, 1999
Withdrawing from your RRSP
March 9, 1999
The economic implications of the euro - An interview with Ranga Chand
February 12, 1999
Underperforming small-cap funds have strong upside potential
January 29, 1999
How to pick a winning equity fund portfolio
January 15, 1999
View the Weekly Insight archive
   

Underperforming small-cap funds have strong upside potential

ROBERT TATTERSALL, CFA, MBA, MA
Portfolio Manager for the Saxon Small Cap Fund
Friday, January 29, 1999

[ Robert Tattersall ] Investing in Canadian small companies has been grim for more than two years now. That may not change immediately, but the downside risk to investors in small-capitalization funds is now historically low and the potential for gains is historically high. The lagging performance of small-caps is not unique to the Canadian market. In fact, small-caps in the United States and the United Kingdom have lagged even worse versus large-caps.

We believe the underperformance of small-caps is a global phenomenon and is primarily the result of the global flight to liquidity. Investors, many of them new to the market, have been concentrating on conservative large-cap stocks and this has resulted in higher valuations today than those of the “Nifty-Fifty” era of the early ‘70s.

[ TSE 300 vs. Nesbitt Burns Small Cap ] Today, we see a major investment opportunity in the small-cap sector. In relation to large-caps, small-caps are now as cheap as they’ve been in several decades. For example:

i)  In Canada, the relative price/book and price/sales ratio of the Nesbitt Burns Small Cap Index versus the TSE 300 is at the lowest level since Nesbitt Burns started recording these statistics.

ii)  On a trailing 12-month basis, the price/earnings (P/E) ratio of the Russell 2000 stands at a discount of five per cent to the S&P 500 P/E, the lowest level since Russell created its small-cap index in 1979. From a price/sales standpoint, the Russell 2000 is undervalued relative to the S&P 500, trading at a 26% discount.

iii)  UK smaller company stocks now offer a higher income yield than gilts, for the first time since 1966. The gross yield on the FTSE Small Cap index has risen to 4.75 per cent, while the yield on the benchmark 10-year gilt has dropped to 4.68 per cent.

Taking a long-term view of the market, we look at the results over the last 48 years from the 1988 Financial Analysts Research Foundation study by White & Hatch and more recently from Nesbitt Burns. Past performance is not always an indicator of future results, but history can reveal significant facts about the relationship between small-caps and large-caps, which may be useful in a  forward-looking analysis.

We can trace the recent cycle of small-cap underperformance back to 1994. The period from 1992-to-93 was the last time small-caps outperformed for an extended period. At the time, it was a welcome recovery for small-caps after nearly seven years of underperformance, from 1983 to 1990. Looking back to the ‘70s, we see a situation not unlike today. This market’s resemblance to the two-tier market of the early ‘70s is eerie and, in fact, we feel the outcome will be similar. From 1971-to-1980, with the exception of 1974, small-caps dominated large-caps for the same two reasons we see today: large-caps are notably overvalued, while small-caps are extremely undervalued.

Remember, over the long run, small-caps have demonstrated better performance. The annual rate of return for small-caps from 1950 through 1997 is 14 per cent, while the annual rate of return for large-caps over that same period is only 11.1 per cent. We believe this three percentage point differential in favour of small-caps is a reasonable objective over the long haul. Hence, we believe that investors should allocate an appropriate percentage of their portfolio to small-caps and then let nature take its course.

By Robert Tattersall, CFA, MBA, MA, Portfolio Manager for the Saxon Small Cap Fund

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