Small-capitalization stocks have been on a tear since the March, 2009, low. Just take look at the sizzling-hot iShares Canadian S&P/TSX Small-Cap Index Fund .
This small-cap exchange-traded fund (ETF) is currently up about 75 per cent since the March low. By comparison, the iShares Canadian S&P/TSX Composite Index ETF is up about 50 per cent.
"Halfway through a recession when the light at the end of the tunnel appears, the small caps take off like a bat out of hell," remarks Sebastian van Berkom, a small-cap specialist and chief executive officer of Montreal-based Van Berkom and Associates.
A recent analysis by Toronto-based Sionna Investment Managers estimated the extent by which small caps beat the market during recoveries. It found that the BMO Small Cap Index, one of the Canadian indexes by which small caps are measured, surpassed the S&P/TSX Composite Index by an average 13.1 percentage points in the 12 months following the five "significant" recessions between 1970 and 2008.
One reason small caps catch fire is that their valuations became relatively more depressed during the recession than their larger cap peers. Insolvency and other risks are higher with small caps, so investors flee to safer investments. But when the economy turns and boosts investors' appetite for risk, small caps are seen as good bargains.
Small caps are also seen as less risky as the economy mends because bank credit and other forms of capital become more available to smaller companies. Yet another consideration is that small caps can ramp up their earnings more quickly because their response times are more flexible, among other factors.
But having had such a strong run lately, are small-cap stocks just about at the end of their hot streak? Is it time to reduce exposure in favour of some other asset class, say large-cap stocks?
Not according to Martin Ferguson, portfolio manager of the small-cap Mawer New Canada Fund. "I believe the recession ended in the third quarter of 2009, so we are only six months into the recovery. Going by the history of the BMO Small Cap Index, there should be another six months left."
"Moreover, policymakers are still plying stimulus," adds Mr. Ferguson. "Monetary and fiscal policies remain at full throttle."
Mr. van Berkom shares this view. "The recovery has not matured yet," he says. "There should be another six months to go for small caps." But he adds a caveat: "However, I do fear we are getting more into bubble territory, especially in the materials sector where the average gain in small caps is over 100 per cent since the low point."
U.S. small caps also have a good track record after recessions. They have outgunned the S&P 500 an average 12 percentage points in the 12 months following the nine recessions from 1953 to 2001, note Sionna Investment Managers.
This time around, however, the picture is a little cloudier in the U.S. Its banking system was traumatized by the financial crisis, and bank credit is still contracting, even several months into the recovery. Thus, small companies in the United States may still find it harder to gain access to capital.
Whether or not small caps continue to outperform in 2010, there will always be individual companies whose shares should do well in most environments. Mr. van Berkom and Mr. Ferguson offered several recommendations in this regard.
Mr. van Berkom's top picks: Equitable Group Inc. , a mortgage lender benefiting from the housing upturn "yet it still trades below book value."
MacDonald Dettwiler & Associates Ltd. , a technology firm whose systems division is "good at developing business in the satellite and robotics areas," and whose products division is "expected to boost sales in the U.S. from marketing its computerized system for real estate transactions and valuations."
Logibec Groupe Informatique Ltd. , a company growing at more than "20 per cent annually by providing IT solutions that hospitals use to manage their accounting, scheduling and other tasks."
Mr. Ferguson's top picks: Canadian Energy Services LP , a leader in drilling fluid systems for the oil and natural gas industry that is growing market share and making acquisitions in a fragmented industry.
Paladin Labs Inc. , a pharmaceutical company enjoying strong growth as a marketer of small-scale drugs in Canada.
Mr. Ferguson and Mr. van Berkom look at many variables when assessing the long-term prospects for small-cap companies. Two of the more important are: competitive advantages, such as patents or pricing power, and management.
Competitive advantages are especially important to Mr. Ferguson. "It's these competitive advantages that allow a company over the long term to generate a higher return on their capital," he said.
For Mr. van Berkom, management is the key. "The three most important criteria to successful investing in small caps are management, management, management."