Penny Shares Worth a Punt

published 31 October 2005

If you'd been shrewd enough to put your money into small company shares a year ago, you'd have enjoyed "a fantastic run for your money", says David Blackwell in the FT. Just look at the Hoare Govett Smaller Company index (compiled by London Business School in conjunction with ABN Amro). In 2003 the index, which covers the bottom 10% of the market by value, rose 36%. This isn't entirely surprising, says Jonathan Davis in The Independent. It makes sense that in a severe bear market - like the one we have just seen - smaller companies are likely to be "hammered". Their businesses are "by definition more vulnerable to economic conditions" and interest in them dries up fast in bad times. It follows that, as investors scramble to get back into the market, it is the small and illiquid stocks thatwitness the most dramatic price gains. Strong price performance then "hits the radar screens of the professionals" and the trend turns into a virtuous circle as they, too, invest. This is precisely what happened in 2003, and not just in the UK. In markets around the world, small caps have outperformed their larger counterparts.

So small really is beautiful, says Ben Laurance in The Mail on Sunday. But look even further down the scale and you will see that "tiny is exquisite". The MicroCap index (also compiled by London Business School/ABN Amro) shows that the smallest 1% of UK-listed firms made an "astonishing 66% jump" in 2003. Indeed, as Paul Marsh of London Business School puts it, "If you had stuck to the absolute minnows you would be asking, What bear market?'" Even factoring in last year's bounce, the FTSE All-Share fell 22% from 2000 to the end of last year. The MicroCap index gained 46.8% over the same period. And that's not just a short-term thing. An investment of £1 made in the stockmarket at the start of 1955 would have grown to £486 in nominal terms (ignoring tax and commissions but assuming dividends are reinvested). A pound invested in the smallest 10% would have increased to £1,513. But putting that pound into a "micro company" would have yielded £8,123. That's an average return of 20.2% a year. So does that mean it is "time to fill your boots" with tiddlers? asks Robert Cole in The Times. Not necessarily. For starters, there's "no guarantee that past performance will be replicated in the future". And shares in tiny firms can be hard to get hold of and even harder to sell. Buying and selling prices can move against investors in "sharp and damaging fashions". That makes it hard to beat, or even track, a micro index. Research costs are also higher as small firms have less time and effort lavished on them by brokers. Finally, there is the risk that as a minority shareholder you could find a majority shareholder - perhaps the founder - "running roughshod over your interests".

All this makes some of the gains from small caps "rather like the Holy Grail - very attractive in prospect, but hard to grasp", says Philip Coggan in the FT. But that aside, now may not be the best time to be looking at small caps anyway. Consider them in value terms. The data suggests that the p/e ratio for the Hoare Govett index is 16.7 times below the All-Share's 19.2 times. But that excludes the loss makers on the grounds that losses distort the data. That "makes me nervous": if we are excluding loss makers from the p/e ratio, surely they should be excluded from the performance data, too? Then there is the dividend. At 2.6% it is low relative to that offered by the All-Share (3.1%), but also low in absolute terms: index-linked gilts offer a no-risk real return of 1.9%. Put all this together and it seems clear that, although the potential for individual small caps to outperform is always high, as a group they may have had their run for now. If you didn't buy small caps last year, "you may have missed the boat".