Minnows beat market's big fish: Recovery at home has helped small company shares to regain their ascendancy, says Tom Stevenson

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FIGURES from Hoare Govett, the securities house, next month will show that the recovery has finally trickled down to the stock market's tiniest constituents. This year, for the first time since 1988, shares in the smallest companies will have outperformed the FT-SE 100 giants.

With only a few trading days left in 1993, Hoare Govett's smaller companies index stands 33 per cent higher than at the start of the year. That compares with a 14 per cent rise in the Footsie, 16 per cent growth for the top 350 companies, and 17 per cent for the All Share index (something of a misnomer as it only includes about 800 companies).

Hoare Govett's index measures the performance of the firms making up the bottom tenth of the market, as measured by market capitalisation, and includes about 1,500 shares.

Its verdict is confirmed by a rival measure, the FT-SE SmallCap index, which measures All Share companies other than the top 350. Their share prices have risen by 30 per cent this year.

The big gap between the performance of small and larger companies marks a decisive break with the past four years. Despite rising in absolute terms in three of the four years, the Hoare Govett index has underperformed the All Share in each one.

Four consecutive periods of underperformance is unprecedented in the history of the index, which tracks share prices back to 1955. In fact, it is rare for larger companies to do better than the tiddlers at all.

Previous periods of underperformance (there have only been seven in almost 40 years) have coincided with recessions. Outperformance has broadly accompanied the bull markets that followed those downturns.

Before the latest dismal run, small companies fared worse than their larger brethren in 1982, 1980 and 1975, although not since 1966/67 had they done so for two years in a row.

In the six years from 1984 to 1989, small companies as a group grew faster than the market every year. There were similar runs from 1969 to 1974 and from 1976 to 1979.

John Houlihan of Hoare Govett believes the weakness of the past four years has been a blip, if an unusually long one. He cites several reasons for the buoyancy of the past year:

Historically, small companies perform well during periods of economic recovery at home. Unlike the Footsie constituents, they tend to depend heavily on the health of the UK economy.

In a recession, investors try to gain exposure to overseas markets, which they can only do by buying shares in the largest companies. During recovery, the outflow of investment funds is reversed.

In 1974, for example, the smaller companies index fell by 50 per cent as investors sold everything but the bluest of blue chips. The following year, as it became clear that the Armageddon implied by a 70 per cent fall in the market had not occurred, small companies produced a total return of 116 per cent.

Recovery at home during 1993 was accompanied by growing worries about the economies of Continental Europe, increasingly the most important market for the UK's biggest companies. That accelerated the flow into domestically based issues.

During the recession, small companies suffered an unprecedented squeeze both from the banks and the larger companies they supplied. When recovery arrived this year, the ones that had survived the onslaught were in relatively good shape and able to benefit from increasing volumes.

The dramatic fall in interest rates after the pound left the exchange rate mechanism gave small companies, which tend to be more heavily borrowed, a disproportionate boost. The interest bill had eaten up a large chunk of many companies' operating profits when the base rate was 15 per cent; at 5.5 per cent it is less of a problem.

Perhaps the most important factor, though difficult to measure accurately, is that the Footsie index has a heavier weighting in the sectors that have performed least well over the year.

The health and household sector, for example, has suffered from the market's disenchantment with pharmaceutical stocks, falling 16 per cent during the year. The relative size of two companies, Glaxo and Wellcome, compared with the rest of the FT-SE 100, means that their poor performance (down 12 and 34 per cent respectively) has dragged down the overall performance of the top shares.

Food retailers have also had a poor run, and the relatively poor showing of the Footsie has owed something to the presence in the index of Sainsbury's, Argyll and Tesco.

Mr Houlihan thinks that small companies will continue to outperform next year, although the extent to which they do so will depend on how quickly the Continental recession is perceived to be easing.

If Germany and France stay in the doldrums then investment interest will continue to focus on domestic recovery stocks. If, on the other hand, those economies start to recover, or are expected to do so in 1995, the larger companies will regain their relative attractions.

Historical precedents provide few clues to the likely out-turn next year. When the 1974 recession bottomed out, smaller company shares enjoyed a massive rebound in 1975. However, they ran out of steam in the following year, beating the market but registering only a 4 per cent rise.

After the 1981 recession ended, by contrast, small shares grew at more than 20 per cent a year for seven consecutive years.

Investors might take heart from the fact that the last period of consecutive underperformance (in 1966/67) also came before a devaluation of sterling.

In the following two years, as interest rates fell from the then crisis level of 8 per cent, shares produced returns of 37 per cent and 47 per cent. If the comparison is valid, next year could well be another good one for the sector.

The best way for small investors to participate in any growth from smaller companies next year would be through a specialist unit or investment trust.

Over the past 12 months, according to figures from Micropal, smaller company unit trusts have just outperformed the Hoare Govett index, rising 37 per cent on average.

Investment trusts, which have a number of advantages over unit trusts including the right to borrow money to gear up into a rising market, have done even better. The average smaller company investment trust grew by 87 per cent last year.

It would, however, be an act of great faith to expect anything like that growth again.

(Photograph and Graph omitted)