Be Wary of Small Cap Bubbles

If you want to see what's going on in the UK economy or the market there's really no need to read the heavyweight financial pages every day. A quick flick through the tabloids tells you everything you need to know.

Take this week. First there was the sign-of-the-times story from eBay about a young man who has bought so much electrical gadgetry over the last few years (multimedia systems, plasma TVs, several electric guitars, etc) that he is now deeply in debt and finds that to get back on an even footing he has to sell everything he owns at a substantial discount to the prices he paid for them.

This tells us everything we need to know about today's consumers: they've spent the last four years buying a lot of pointless rubbish (who needs more than one electric guitar or indeed any electric guitars?). Now they're in debt, they're nervous and they're not buying any more of it. No wonder the CBI says the situation on the high street is the worst it has been in 22 years Next there was the bankruptcy of Furnitureland which turned up as a shock horror story everywhere from the Sun to the Star. This confirms what we already know about consumers, and also tells us all we need to know about the housing market. Transactions have collapsed over the year and less people moving house means less people buying new sofas.

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Of the most immediate interest to equity investors however, may be the pages of ads for new fund launches trying to attract our Isa money. These are fantastic indicators of where the market is going. Funds are easier to sell at the end of a bull market than at the beginning and fund management companies tend to care more about selling funds than making returns for investors in those funds.

As a rule of thumb the more funds launched in any particular sector the more likely that sector is to underperform. So what kind of launches are we seeing most of at the moment? Residential property funds and specialist small cap and Aim funds. I don'think I need to comment particularly on the former except to say that the market is remarkably skilled at separating fools from their money.

But the latter is of rather more interest. The arguments for investing in smaller companies are incredibly compelling. It is obviously an awful lot easier to double the size of a firm turning over a mere £1m than one already turning a couple of billion, and doubling the size of a firm often means more than doubling the share price. At the same time the smaller company markets seem to offer investors a much more level playing field than the larger ones. As they are less widely followed than the nation's blue chips or mid caps there is, or so the story goes, much more chance that the average investor will be able to find cheap stocks the professionals have missed.

All in all the opportunities to make big money seem splendid: had you invested in the five biggest gainers in the FTSE 100 over the last year you'd have made an average return of 75%. But if you'd put the money into the five biggest gainers listed on the Aim market you would have made an average return of 471%. And Aim as a whole has also done fantastically over the last three years, rising 90% (hence all the new fund launches).

Makes you want to just throw money into small caps doesn't it? Well it shouldn't. I can't understand why small companies are all lumped together as though they were all somehow the same. It's like the way hedge funds are always spoken of as some kind of homogenous assets class when they are not. All hedge funds have in common is that they aim to make absolute returns. And all small caps have in common is that they are small.

Look back at the 471% gain I mentioned earlier. The out-performance here wasn't anything to do with smallness in itself. It was to do with the mini-bubble in resource stocks: of the top five performers in question, two were resource stocks and the average was hugely skewed by the fact that one of them Asia Energy rose 800%.

It is also well worth noting that the Aim market as a whole hasn't been much of a winner since its launch 10 years ago: the FTSE 100 has risen a respectable 46% in the last decade but Aim has managed to clock up only 11%. In fact the only two periods in which Aim has significantly outperformed have been the last three years (this has, as discussed been nothing to do with size, but with the huge number of new listings in the booming resource sector) and 1999-200 when it leapt nearly 300% (again this was nothing to do with smallness and everything to do with the tech bubble) My point here is not to say that you shouldn't invest in smaller companies. Instead it is just to say that you need to be aware that you can't look at them as one big group. They're all different and so need to be looked at by sector and analysed individually. A general Aim fund is not the place to be when the market realises that although any oil and gas exploration company can explore for resources, very few ever actually find them (resources now make up 30% of the Aim market).

As ever, success here is all about picking the right stocks. Unfortunately, doing this involves at least as much work and usually a great deal more as picking larger company stocks. You need to look for firms with low valuations, strong balance sheets, intelligent management and growing revenues. It doesn't matter which market you are looking in, it is always a great deal easier to find bad companies that are overvalued than to find good companies that are undervalued.

By Merryn Somerset-Webb, editor-in-chief, MoneyWeek

First published in The Sunday Times 2/10/200