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.
Information in The Penny Sleuth is for general information only and is not intended to be relied upon by individual readers in making (or not making) specific investment decisions. The Penny Sleuth is an unregulated product published by Fleet Street Publications Ltd. Fleet Street Publications Ltd is authorised and regulated by the Financial Conduct Authority. FCA No 115234. http://www.fsa.gov.uk/register/home.do