Smaller Companies: Outstanding performance as the gap grows

THE Hoare Govett smaller companies index underperformed the rest of the market for the fourth year running in 1992. So the latest figures, showing impressive outperformance so far this year, will come as a welcome relief to followers of this column.

According to John Houlihan, head of smaller company research at Hoare, the extended index, excluding investment trusts, has risen by 27 per cent since January. The FT-SE 100, by contrast, is just 6 per cent higher, while the FT-SE 250 and All Share indices are both 10 per cent ahead.

There are good reasons for the outperformance. Lower interest rates favour smaller companies more than their bigger brethren because they tend to be more heavily borrowed. They also have a heavier exposure to the domestic economy so benefit more from an upturn at home.

Perhaps more importantly the smaller end of the market tends to include more cyclical companies and fewer of the defensive but currently out of favour businesses such as drugs companies and utilities.

Looking ahead, however, Mr Houlihan warns that the renewed enthusiasm for shares has pushed the market to a level where expectations are likely to be disappointed. When that will happen is impossible to tell but he suggests that the interim reporting season in September could be a watershed.

It is quite usual as the economy pulls out of recession for the stock market to be looking a long way into the future recovery. But Mr Houlihan thinks that the market's optimism might be difficult to reconcile with results that are looking backwards at the first six months of the year, which for many companies were still difficult.

Of course, expectations are not the only force driving the stock market to new highs. It is also reacting to the weight of money flowing from investors who are dissatisfied with available returns from other investments such as deposit accounts and gilts.

Common sense dictates that the run cannot continue for ever and it is worth noting that the market is on a forward price/earnings multiple that has not been seen since 1987, just before the crash. Before that it had not been so highly rated since the early Seventies.

Bulls of shares say that things are different now. Inflation is lower and interest rates are likely to stay low. That is true, but so is the counter- argument that dividends are likely to grow much more slowly than in the past. In fact they are still falling.

If dividends are growing slowly, a yield of less than 4 per cent offers little protection. Any further fall in the market's yield and the income attraction of shares will disappear. An upward move in base rates will accelerate the move back into deposit accounts.

All this is especially bad news for smaller companies - the recent surge in their shares makes them doubly vulnerable if the market runs out of steam during the results season.

It is an old adage that when the cabbies start offering you tips the stock market is overheated. We are not at the hysterical levels of the summer of 1987 but investors would be advised to treat tips they hear over the next few weeks with caution.

It would be very surprising if Hoare Govett did not announce the first smaller company outperformance of the market for five years in six months' time. But it would be quite something if the gap between big and small were as pronounced as it is now.