This bull market could run and run

As investors, 2013 was good to us.

And for those of us who focus on smaller companies I would go one further. This is a proper bull market.

For proof, just look at the numbers. The UK’s small-cap index is up around 27% from year’s start to mid-December. Compare that to the 10% rise in the FTSE 100. And this isn’t a flash in the pan, either. These numbers reflect a persistent trend in the stock market. Over the very long-term, smaller companies produce better returns than large ones. That’s a fact.

All sorts of reasons have been put forward to explain this. The best theory in my view is that investors get better returns to compensate them for the lower levels of liquidity in small company shares.

Whatever the reason, if you’re investing your money in small companies, over time the odds are stacked in your favour.

Of course, we’re never guaranteed superior returns. During the financial crisis small-cap companies did far worse than big ones. But in 2013 they’ve done a lot better and the size of this premium has certainly been eye-catching.

Why Aim thrashed the FTSE

So what’s been happening? It really has a lot to do with the make-up of the FTSE 100. If we look at the UK’s mid-cap index – which covers companies worth between £400m and £3.5bn – we see it’s risen by 24%. That’s only a little bit behind the small cap return.

The thorn in the FTSE 100’s paw is its many miners and oilers. These companies remain out of favour. Case in point: Fresnillo – the precious metals miner – is the worst performing share in this index, down 60%.

The FTSE is also home to a lot of big, good quality defensive stocks like supermarkets and tobacco companies. As you’d expect, these companies have lagged behind during the onset of economic recovery. Those type of stocks tend to do fairly well in bad times and good.

This last point about there being a recovery still feels a bit controversial. Many commentators have taken a long time to come round to the idea. Most pundits still question the health of the recovery. In fact, they’re full of reasons why it won’t take hold and is bound to fail.

My experience tells me that these feelings are normal. Every recovery I have ever witnessed looked fragile and dubious at first. In fact, I’d even say that worries about recovery are healthy for the stock market.

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It’s not time to worry yet

Why’s that? Well, bull markets are said to climb a ‘wall of worry’ as sceptics slowly come over to the bull cause. The paradox of investment is that the real time to worry is when the news is all good. At that point, because everyone is positive and fully committed to shares the only way is down. There is no one new left to buy. Recovery worries demonstrate that people are trying hard not to get carried away. That’s a good thing.

In a recovery we’d expect cyclical shares – that is, shares sensitive to ups and downs in the economy – to do well. Equally we should not be surprised by the strong performance we are seeing from smaller company shares. They tend to be more exposed to the fluctuations of the economy than big companies. And their shares are less liquid which makes their share price more exposed to sentiment in the market.

So how do I feel about all this? That’s what I ask myself. And I ask it because I find my gut instinct’s very helpful for gauging where we are at in the market cycle. I’m not pretending I always get it right, no-one does. But I know that if I feel particularly pleased with myself, then I ought to be selling. I am reminded of that wall of worry – if everything feels great, you’ve probably hit the top.

But I don’t feel as smug as I would expect to, given the market’s return this year. In fact, I feel a bit… guilty about it all. This guilt comes from the media telling me that it’s not a real recovery; that it’s all based on central bank manipulation.

It also comes from being told by every publication I read that share valuations are too high. And it’s not just me, either. Looking around, I don’t see any signs of complacency, let alone the euphoria that I might expect at a peak in the market.

A golden age for equities?

So I think that despite the great year we’ve had investing in smaller companies, there are more opportunities for us to take on. We’re still in the early stages of a recovery after a long period of contraction. Being led upwards by smaller companies and cyclical shares, the stock market reflects this. There could well be setbacks. It would be unusual if there weren’t. But overall it seems right to stick with the plan.

Thinking longer-term, we could be at the start of a new golden age for equities. Bond yields have finally bottomed out at abnormally low levels after a 30-year bull market. By contrast, in the last decade, equities have been battered by two devastating bear markets.

2013 has been good to us. One factor that could drive a sustainable period of strong equity performance in 2014 and beyond is the emergence of exciting new industries and technologies. There are a number of areas with exciting potential and I will talk about the best opportunities for 2014 in the next edition of Penny Sleuth.

This article is taken from our FREE penny share investment email Penny Sleuth.
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4 Responses

  1. 26/12/2013, richard tavener wrote

    One caveat I’d make concerning further outperformance by small companies is their reliance ( in many cases ) on the U.K economy relative to the FTSE -100 whose constituents derive c70% of their earnings from abroad. Since the U.K economic recovery to date has been fuelled by consumer spending, this surely cannot last while real incomes are still falling and personal debt is at an all-time ” high “. Unless we can reverse c50 years of decline in manufacturing, the present economic rebound cannot continue, so one should only consider smaller companies with large overseas earnings and also be very careful of where these profits actually come from.

  2. 27/12/2013, mr clyde wrote

    The article also fails to highlight massive fiscal game-changers:
    Freeezing of IHT nil band
    Lowering of Pension life-time limit
    Allowing AIM shares to be held in ISAs
    IHT relief for AIM after two years
    = Potential massive demand for quality, qualifying Small Co stock. Well, until the government changes the rules!!

  3. 27/12/2013, jimtaylor wrote

    For the FTSE100, and probably the FTSE350 as well, I think it is more of a Recovery rather than a Bull Market. The £ is currently worth around 20% less than in 2007 due to inflation, so share prices still have some way to go to get back to where they were pre-crisis, adjusted for inflation effects on the value of the £.
    I expect the next 2 years to be slow and steady as larger companies get back to where they would have been.

    I agree to some extent that there may be something of a Bull Market for small and start-up companies as the economy and large companies recover, but there is always the opportunity to lose as much as you make particularly on AIM.

  4. 04/01/2014, modsa wrote

    I think to clasify the smaller company market as a “Bull market” is far too simplistic. There are some great opportunities to both make and lose money. We all know about the “greedy” bankers; but investors need to remember there are plenty of greedy senior board members driven by a desire both for cash and/or status. The interests of investors are often subordinated to these desires. At one AGM we were told that the Chairman wished it had remained a private company! This because he was being pressed to give some idea of when it would start paying dividends. His concern was to raise the share price and hence the notional value of the company thus benifiting the Directors but leaving all the risk with the investors. Many other small companies follow the same tactic. I would advise, go to the AGM and watch the body language.

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