U.K. small-cap companies are outperforming, as investors anticipate additional stimulus from the Bank of England.
The FTSE SmallCap Index -- currently made up of companies with market capitalization of less than 392.1 million pounds ($623 million) -- has risen 10 percent so far this year, compared with a 5.7 percent gain for the FTSE 100 Index (UKX), which represents about 80 percent of the U.K. equity market.
These stocks “snapped back” after about four months of underperformance when concerns about another euro-area recession peaked, said Graham Bishop, an equity strategist at Royal Bank of Scotland Group Plc in London. The possibility of further stimulus measures has created a “pro-growth bias” for this asset group, he said.
The Bank of England’s nine-member Monetary Policy Committee will increase the ceiling on its bond-purchase program by 50 billion pounds to 325 billion pounds at the meeting that begins today, according to the median forecast of 50 economists in a Bloomberg News survey. Policy decisions are scheduled to be announced tomorrow.
Adam Posen, a member of the committee, is “leaning” toward more stimulus because “there’s a case” for raising bond purchases by 75 billion pounds, he said in a Feb. 2 interview with Bloomberg Television.
The central bank has left the door open for further asset purchases to prevent inflation from falling below its 2 percent target, Governor Mervyn King said Jan. 24 during a speech in Brighton, England. As price and wage growth have eased, there also “is scope for interest rates to remain low,” he said.
Record Low Rates
The bank will hold its benchmark rate at a record low 0.5 percent at the meeting, according to 56 economists in a separate Bloomberg survey.
Small caps, with higher risks and potential rewards, experienced a “real and immediate boost” on King’s announcement, as the FTSE SmallCap broke its three-month high relative to large-cap peers, according to Jim Stellakis, founder and director of research at New York-based research company Technical Alpha.
The possibility of more so-called quantitative easing has spurred “a general increase in risk appetite,” so “investors are going back to smaller stocks because they feel they’ll get more bang for their buck,” said Keith Wade, chief economist at Schroders Plc in London.
Using “classic policy,” the central bank is encouraging investors to move out of low-return Treasury assets and into equities, said David Hensley, director of global economic coordination at JPMorgan Chase & Co. in New York. It may be more aggressive in trying to stimulate economic activity, particularly “if the U.K. looks like it’s contracting again,” he said. Britain emerged in 2009 from the deepest recession since World War II.
U.K. small caps generate about half their revenue domestically, so another slowdown might hurt their performance, Bishop said. Gross domestic product shrank 0.2 percent in the fourth quarter from the third, according to data released Jan. 25 by the Office for National Statistics.
Wade and his colleagues are forecasting a 0.4 percent contraction for 2012, following an estimated 0.9 percent expansion in 2011, because of a “knockdown effect” from a euro-area recession, he said. That probably will create a sluggish backdrop for consumer demand and business investment, while causing further job cuts and a drop in exports, he added.
This means central-bank policy may be “buying time” for a liquidity-driven rally, said Gary Baker, head of European equity strategy at Bank of America Merrill Lynch. Along with the fourth-quarter slowdown, credit availability for small businesses remains “very tight,” so these companies “need economic growth more than any other group,” he said.
Earnings forecasts for equities have moderated, so investors may cherry-pick companies that can establish new business drivers or take market share from larger competitors to spur revenue, said John Leahy, a fund manager at Hermes Investment Management in London.
When making selections for its small- and mid-cap fund, Hermes focuses on “higher-quality stocks that should outperform in a world where growth is scarce,” he said. Even though small caps may be attractive now, “investor risk appetite can change very quickly.”
Spirit Pub Co (SPRT)., owner of the Chef & Brewer and Flaming Grill chains, has outperformed the FTSE SmallCap Index (SMX) by 16 percent since Dec. 30. So-called like-for-like sales at its managed-pub locations rose 6.2 percent in the 16 weeks ended Dec. 10, the Staffordshire, England-based company said Dec. 16.
IP Group Plc (IPO), which develops intellectual-property-based businesses, has led the FTSE SmallCap by 20 percent since Dec. 30. The London-based company owns a 21.5 percent stake in Oxford Nanopore Technologies Ltd., which is planning to market DNA strand-sequencing products directly to customers this year.
Even with the Bank of England helping to create a “pretty bullish outlook” for small-cap stocks, the group still is trading at a discount of about 13 percent relative to large caps on a price-to-earnings ratio, compared with a 10 percent premium during the past decade, Bishop said.
“There’s still upside potential even after the latest rally,” he said.
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