LONDON -- Thinking small in the U.S. is proving to be an increasingly costly business. However, U.K. small-cap stocks are relatively cheap and with money pouring in from the funds industry and earnings estimates that outstrip their larger cousins, they look set for another sterling performance this year.
index is trading at an average current price-to-earnings ratio of 34 times. According to
, a financial-information provider, the average P/E ratio for the
FTSE Small Cap index
-- the nearest equivalent in the U.K. to the Russell 2000 -- is around half that at 15.1 times. Not only does this look enticing compared with U.S. valuations, it is also well below the 20.1 times for the blue-chip
Much of this inherent value can be explained by the relatively poor performance of small-caps leading up to last year. In 1998, the FTSE Small Cap index fell 10.5% compared with a gain of 14.6% for the FTSE 100, and in 1997 small-caps rose 3.0% vs. 24.7% for blue-chips.
The sector, though, turned around last year. I/B/E/S predicts that average earnings growth in fiscal 1999, which hasn't ended yet for all companies, for stocks within the FTSE Small Cap index will be 16.8%. It warns that may be too optimistic, yet it would take a large decline to equal the 8% growth expected for the FTSE 100 companies in 1999. This year, the average earnings growth for small-caps is expected to be even better at 17.3%, compared with 15.6% for stocks in the FTSE 100.
Unsurprisingly with this type of earnings growth, the share prices of small caps performed well in 1999. The FTSE Small Cap index rose 49.6% during the year and the index for London's
Alternative Investment Market
, or AIM, rose an astonishing 141.1%. The FTSE 100 index, on the other hand, rose only 17.8% in the year.
That's been good news for Americans who invested in small-cap European funds, many of which hold U.K. stocks. The
DFA United Kingdom Small Company fund was up 35.4% over the past one-year period.
So with comparatively good valuations and the prospect of solid earnings ahead, should investors pile into these small caps? Yes and no.
Moving to a Techno Beat
Like markets the world over, the technology sector has left, and is leaving, the other sectors standing. According to the brokerage
Teather & Greenwood
, in the 11 months to November 1999, the IT hardware sector rose 230%, the IT sector by 93%, and software and computer services by 78%.
"The IT sector is growing at three times the rate of the U.K. market as a whole," says Peter Ashworth, head of smaller-companies research at
Needless to say, smart money follows the winners. A survey by the advisory firm
found that U.K. fund managers have a net 17% more funds this year to invest in smaller quoted companies. Much of this will be allocated to the technology-based sectors such as software and computer services (up 66%) and support services (up 60%), at the expense of more traditional sectors such as general retailers (down 26%) and engineering machinery (down 28%).
KPMG notes in its report that "we are seeing here the development of a two-tier, smaller-quoted market with increasing focus on technology sectors."
If this sounds like the familiar story where the retail investor is crowded out by the institutions then that's probably because it is. However, Guy Feld, technology analyst at Teather, said there is still value to be found in the sector if you look hard enough.
"Despite recent share price rises, there are still attractively valued ... smaller technology companies with good long-term growth prospects and sitting on multiples which do not appear to be exorbitant," Feld said.
Companies he would include in the category are
ICM Computer Group
Rolfe & Nolan
. Teather has an investment banking relationship with the latter two companies.
Of course, if the above companies are as undervalued as Feld seems to think they are, they are unlikely to remain so for long. Yet thinking small has never been synonymous with thinking slow.