Judging value in small and mid-cap space

Sunday, 15 August 2010

By TEH HOOI LING
SENIOR CORRESPONDENT

Small caps are inherently riskier, and during a downturn a lot of smaller companies get whacked harder

I SPOKE to Singapore-based value fund Lumiere Capital earlier this year. During the interview, one half of its founders, Wong Yu Liang, said: 'If you look at the measurement for the FTSE Small Cap Index, it has dropped 80 per cent from top to bottom. During the Great Depression, the price decline was 89 per cent. So we had a Great Depression in the small-cap sector in Singapore.' Mr Wong's contention was that there was still a lot of value in the small and mid-cap space.

I checked the numbers. The Small Cap Index hit a peak of 1,045.38 points on July 12, 2007. After the world's financial system seized up following the collapse of Lehman Brothers, it plunged to 236.76 points by March 12, 2009. That, to be exact, is a decline of 77 per cent. Not quite as bad as the Great Depression - but bad enough. In comparison, the Mid Cap Index was down 76 per cent, while the bluechip Straits Times Index (STI) shed 67 per cent during that period.

Just as swiftly as prices came down, so they recovered. But there have been different degrees of recovery for companies of different sizes. From the low of 2007, the Small Cap Index has rebounded 126.5 per cent. Its bigger counterpart, the Mid Cap Index, surged 143.2 per cent. And the giants of the stock market, the STI components, just about doubled from the bottom. From another perspective, as at Thursday's prices, the STI was just 20 per cent away from its peak in 2007. But the Mid Cap Index was still 31 per cent below its 2007 peak. And the Small Cap Index? It was still a whopping 49 per cent away from its 2007 high.

Since I'm at it, I decided to compare the performance of these three indices from different starting points up to this week. The charts show the movements of the three indices over time from various starting points. As you can see, the Small Cap Index is almost consistently at the bottom - that is, the worst-performing index.

For example, from Aug 31, 1999 until this week, the Small Cap Index actually lost 42 per cent of its value. In contrast, the Mid Cap Index was up 43 per cent, while the STI gained 38 per cent.

The Small Cap Index under-performed both the Mid Cap Index and the STI in all but one of the past 11 years, assuming one had invested at the start of each year since 2000 and held on until this week. Only from the start of 2009 until now did the Small Cap Index manage to pip the STI. And it never matched the performance of the Mid Cap Index. Perhaps current depressed valuations for small-cap stocks have something to do with index's dismal return numbers. So I calculated the rolling one-year, two-year, three-year and five-year returns of the three indices between Aug 31, 1999 and Aug 12, 2010. There were, for example, 2,498 one-year periods between that period. And there were 2,248 two-year periods, and so forth.

I then found out the median return of the various holding periods for the three different indices. From the second table, you can see that again, the Small Cap Index is the worst performer. The median one-year holding period was -4.1 per cent. This compared with 11.2 per cent chalked up by the Mid Cap Index, and the 9.3 per cent by the STI. In other words, for one-year holding periods, the Small Cap Index under-performed the Mid Cap Index by a whopping 15.3 percentage points, and it trailed the STI by 13.4 percentage points.

The under-performance of the Small Cap Index over two-year holding periods was even bigger, at 27.8 percentage points relative to the Mid Cap index and 15.4 percentage points relative to the STI.

Logically, the findings make a lot of sense. Small caps are inherently riskier. They don't generally have the wherewithal to defend their turf should a bigger competitor decide to come in. Bankers and suppliers are generally less forgiving of smaller companies. And smaller companies generally do not have the capacity to dangle a big enough carrot to attract top management talent. Which is why during a downturn, a lot of smaller companies get whacked harder. And some of these whacks can be fatal.

Smaller companies also typically face an uphill task in trying to grow to the next level. The lack of suitable management talent may be one factor. Then there is the lack of experience in managing expansion, in pacing growth at a sustainable level, instead of trying to go for far too much, far too fast. As a result, many smaller companies get tripped up when an unexpected downturn comes along. The big caps of course have a sturdier ship to steer through choppy waters. Hence their returns are typically rather decent.

But the bigger returns can be had from mid-cap companies. These are companies that have gone through the growing pains, chalked up the enough experience to manage growth, and have relatively larger pool of financial resources and more muscle to get up to the next league. My findings confirmed a previous study I carried out. Earlier this year, I looked at the returns of stocks in Singapore over the past 10 years based on the various groups' initial market caps. I found that stocks with market cap of between $1 billion and $5 billion to be in a sweet spot from which to grow their business. They were the best-performing group in the 10 years to 2009. Of the 27 stocks in that category, the median total return was 10.1 per cent compounded every year for the past 10 years. The average was 10.9 per cent. The return included dividend yield.

I noted then that the second best hunting ground for stocks likely to survive the market's ups and downs was in the $500 million to $1 billion market-cap range. The median return of the 18 stocks in that group was 6.8 per cent a year for the past 10 years, with the average at 4.5 per cent. Companies smaller than the $500 million market-cap level have, on average, yielded negative returns in the past 10 years. While size matters, companies that are too big can find it cumbersome to grow as well. Of the 10 companies whose market cap exceeded $5 billion at the start of 2000, the median return was 2.9 per cent a year, and the average was -0.6 per cent.

Hence the past 10 years' record shows that on the whole, investors have a better chance of picking a decent 'buy-and-hold' candidate among companies with market cap of $500 million and above. The chance of picking a 10-year winner there is 75 per cent, whereas for stocks smaller than $500 million, the chance of landing a winner is about 46 per cent.

Not only that, for the small-cap stocks that didn't make it, the likelihood of them tanking royally is greater. Today's findings show that perhaps one year is too long a holding period for small caps.