‘You’ll be out of a job soon, at this rate,’ a friend of mine told me last week, with a cheerful grin.
Hardly a matter to joke about, I thought. But times like these bring out the gallows humour in all of us.
Anyway, what he was referring to was the dwindling pile of data, and news, and commentary, and facts and figures that is the raw material of my work.
My friend is absolutely right. What he means is that the penny share market is shrinking. But I’m not worried. In fact, as I’ll show you, this makes now a very good time to be a small cap investor.
Penny shares are racing ahead
The penny share market is fast sorting itself out and the results are impressive. The Alternative Investment Market (AIM), the market for small companies, has far outperformed the overall stock market, as this chart shows – the AIM index is the red line, the FTSE 100 is in blue.
Clearly a more powerful force is driving small companies than their larger brethren.
This is good news for small cap investors. But it begs the question: what’s going on? Why are small companies outperforming to such a degree? Let’s take a look...
Some of the factors that have been driving the small cap rally actually apply to all companies. Banks are no longer expected to fall upon each other like a pack of cards. Some green shoots have appeared. Some confidence has returned to financial markets.
Sellers have been in retreat and buyers have rediscovered their animal spirits. Crucially this has enabled companies to raise the fresh capital that they need to see them through the recession. Rights issues have been coming thick and fast, bids and deals are back on the agenda. BPP (ticker: BPP), Brixton (ticker: BXTN), and Carluccio’s (ticker: CARL) are just three of several companies to be on the receiving end of take-over approaches. Corporate financiers, who organize these deals and get paid for doing so, are smiling at last.
But there is no particular reason why these factors should affect small companies any more or less than large companies. The outperformance of the penny shares has its roots elsewhere. I can identify four causes.
Four reasons penny shares are beating large caps
The first is that the small company market fell much further in the downswing. Valuations became, to use a word much loved by City analysts, ‘compelling.’ Luminaries such as Jim Slater and Nick Leslau drew attention to the extraordinary undervaluation of small companies and value always wins through in the end.
The second explanation lies in forced selling. Last year managers of small company funds were forced to dump shares upon an unwilling market in order to pay out their own customers. Small company shares are relatively illiquid, and the sale of even a small parcel of shares was able to knock a share price.
Next, small companies are considered to be more risky. I dispute this. While some companies certainly make for more risky investments than others, the reasons are to do with the nature of the business and its financial structure, and not with size.
Nevertheless, to the extent that others believe this fallacy, it becomes self-fulfilling. That means that as the perceived risk of making any kind of stock market investment has receded, so small companies have attracted the bold investor.
But now let me show you why it is the fourth and final reason that really marks out the small company sector…
If small companies are not enjoying their experience on the stock market they can just up sticks and leave. The first rule of economics is that price is determined by the balance of supply and demand. So when small companies were in vogue, a mass of them arrived on the stock market and soaked up investors’ cash. In consequence the index went nowhere.
But now, small company executives are concluding that they would rather not pay fees to the London Stock Exchange and City advisers. So they are retreating to the private sector. The trend is becoming quite a flood. The number of AIM-listed companies that hit 1,694 at the end of 2007 is now down to 1,439, and is falling fast. Fewer shares to chase should – other things being equal – mean rising prices.
And it is happening. Since its low point on 9 March, AIM has risen by 43%. That certainly beats anything that the big boys have managed to achieve. The FTSE 100 share index is up just 22% in that time; the wider All-Share index has gained 23%.
When you look at some of the individual performances of these small companies, you see some quite extraordinary numbers. Three that have caught my eye recently are the Kazakhstan-focused Max Petroleum (ticker: MXP), which is up 500% since 9 March; Cambrian Mining (ticker: CBM) up 447%; and AFC Energy (ticker: AFC), which has leapt a staggering 638% in that time.
I’m hesitant to jump into these now after such blistering three-month gains. But they illustrate a point about the sheer exhilarating potential of small caps – especially in “hot” sectors like energy and mining.
Although my friend is right that the number of small companies we can invest in is getting less, it means better opportunities in the ones that remain.
Best regards,
Tom Bulford
For The Right Side
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Note: Your capital is at risk when you invest in shares, never risk more than you can afford to lose. Seek independent financial advice if necessary.
MARKET NOTES
Warning signal for bank stocks
BY SHIVVY ARORA
After a two-month long rally, bank stocks may just have run their course. We’ve recently been seeing weakness in the sector. This is down mostly to severe ratings downgrades and investors’ waiting on new financial regulation plans from the Obama camp.
One indicator for the sector is the KBW Bank Index, which tracks 24 of the US’s leading banks. It’s run by Keefe, Bruyette & Woods, an investment bank founded in 1962 that follows more than 200 banks on a daily basis. They’re well-known as banking industry experts.
The chart below shows the index (blue line) for the year-to-date. You can see that it enjoyed a strong 135% rally from 6 March to its 8 May high (circled). But since then, the sector has fallen by 17%. And it still hasn’t managed to break through a key level of resistance – its 200-day moving average (DMA; green line).
Financials are showing us warning signs...
Source: Yahoo Finance
Over the past week, we’ve seen a continuing correction in financials. Only last week, credit ratings agency S&P downgraded 18 U.S. banks. Five of these were put into ‘junk’ territory – the lowest end of the debt ratings scale and considered speculative versus good quality “investment grade” debt.
The new rules to govern Wall Street will further tighten regulation – expect to see some of the largest overhauls to market rules since the 1930s. Proposals include plans for the Fed to oversee large financial institutions and policies for previously unregulated markets.
Look at this as a warning sign for investing in financials which have likely already priced in any positive news for the sector. And the expectation of general market weakness and tougher financial regulation means we see the banks on a continuing downtrend.
The Daily Reckoning – Depression is like dentistry – necessary and painful
BY BILL BONNER
Paris, France
Monday, 22 June 2009
There are two major schools of thought on the bailout:
First, that the banks are still in trouble and need to be nationalized (Roubini, Krugman).
Second, that the banks are still in trouble, but that a public/private partnership can recapitalize them as they work their way out of the hole (Geithner, Gross).
As usual, we play hooky. Here at the Daily Reckoning, we’re not in either school.
In our view, the banks are in trouble because they lent too much money to too many people who couldn’t pay it back. They should take the verdict of the market... and hang.
Hey... won’t this cause a depression?
Ah... here is where we really part company with our fellow bipeds. We are in a minority... such a small minority that all its adherents put together could probably fit into an elevator. Because we believe that a depression is just what America needs... and what it’s going to get regardless of what the meddlers do. In fact, we think they will turn an ordinary depression into a Great one. Or maybe even a “greater depression,” as our old friend Doug Casey puts it.
Stocks barely moved on Friday. The Dow lost 15 points. Oil lost $1.76. Gold and the dollar moved little – the former up, the latter down.
California demonstrates what has to happen in an honest slump. They’re preparing for “deep cuts” in school budgets, say the papers. Naturally, the education lobby is howling. But most of the money spent on ‘education’ is wasted anyway. Cutting back might even help kids learn something.
Consumers are cutting back too. That’s probably the most important new trend to come with the post-Bubble era. Consumers are thinking small... smaller houses, smaller utility bills, smaller cars, smaller debts, smaller retirements.
That’s a change that’s likely to stick. They’ve seen where thinking big got them. Now, small is beautiful.
Fore more, including the latest on Argentina… Read on…
To read the Daily Reckoning in full, click here.
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