Weekly Newsletter: February 17, 2014 - Focus on SmallCaps

Weekly Spotlight on: Small-Cap Stocks

While global stock markets have continued their steady recovery following January’s emerging market-led swoon, a difference in performance is emerging between small-cap stocks Stateside and those both located in the UK and also in Europe. 

Now normally, you could expect the performance of small-cap stocks in general to be driven broadly by two factors: 

 Firstly, the direction of the broader stock market, as small-cap stocks tend to have a beta higher than 1 as a group; that is to say, when the benchmark stock market indices are moving higher, small-caps tend to move higher even faster. Conversely, when stock markets are correcting, small-caps tend to suffer more as small-cap liquidity can dry up, causing wider swings in stock prices on lower volumes.

 Secondly, small-caps tend to be driven more by the momentum in the domestic economy than large-caps given their greater domestic exposure. So when the domestic economy is improving rapidly, as it is currently in the UK, you would expect small-caps to be more responsive to this trend and outperform their large-cap compatriots.

Now small-caps are indeed outperforming the large-cap stock indices in the UK and Continental Europe as you would expect given rising stock markets and positive signs from the UK and Eurozone economies. 

UK SmallCap ETF BEats the Footsie Hands Down

Source: Yahoo Finance

However, this is no longer the case in the US, after an impressive 2013 when US stocks did well (the S&P 500 benchmark index gained over 30%) and small-cap stocks did best of all (+37% over calendar 2013!). 

Why might this be? Well, there are some signs that the US domestic economy is not perhaps growing as robustly as was previously thought. Employment growth (as measured by the non-farm payrolls data) has been much weaker over the past two months. 

Now while some of this weakness may be attributable to the extremely cold weather hitting much of the US over this period, there are also lingering suspicions that better US economic growth is not translating into better job growth, suggesting that the peak in domestic US growth may already be behind us. Hence the relative weakness in US small-caps, reflecting these economic doubts. 

A second factor to bear in mind is valuation: US small-caps now sit on average at a hefty valuation premium to large-caps, when traditionally small-caps have traded more often at a discount to the largest US companies. This suggests that for US small-caps to grow into their higher valuations, they are going to have to convince investors by posting superior earnings growth from here on out. 

In the meantime, I think I shall be calling time on my US small-caps ETF strategy, and instead looking at different investment styles for my ETF exposure to American companies. As the eagle-eyed may have spotted in lat week’s weekly newsletter, my favourite ETF/investment trust portfolio includes a Nasdaq 100 ETF (EQQQ.L), rather than any US small-cap ETF, as I am still very partial to US technology exposure. 

But what about UK, Euro Small-Caps?

In contrast, I am still keen on exposure to UK and Euro small-cap ETFs and investment trusts, as the situation here is somewhat different. 

Euro SmallCap ETF Heading Back To Highs

Source: Yahoo Finance

Firstly, the valuation differential between small-cap and large-cap indices is not at all extreme on this side of the Atlantic; if anything, small-caps still trade at a modest valuation discount to large-caps.

Secondly, the economic evidence is different in that the UK and Eurozone are still seeing improving domestic trends. The UK case is relatively clear-cut, with employment growth still accelerating rather than slowing down (albeit disproportionately driven by the “London effect”). 

In the Eurozone, economic growth rates are still modest but are improving, with Friday’s Q4 2013 GDP growth data beating analysts’ expectations. The employment data in the Eurozone is very variable, but we can start to discern slow improvements even in peripheral countries such as Spain and Ireland. 

So for these two reasons, I shall be maintaining my UK and Euro small-cap fund selections in the Model ETF/IT portfolio.

The Idle Investor’s Model ETF & IT Portfolio

The table below details the 6 UK-listed ETFs and investment trusts (3 of each) that I favour at the moment. There are a number of other ETFs and closed-end funds that I am keen on in the US, but have not included here for reasons of simplicity.

Company	Code	Share Price Feb. 7, 2014	Share Price Feb. 14, 2014
iShares MSCI UK Small-Cap ETF	CUKS.L	15,027p	15,276p
Source GLG/Man Europe Plus ETF	MPFE.L	10,999p	11,126p
iShares Japan GBP-Hedged ETF	IJPH.L	4151p	4136p
Inveco Perpetual Enhanced Income IT	IPE.L	73.0p	72.0p
Fidelity Asian Values IT	FAS.L	198p	202.5p
Herald IT	HRI.L	715p	726.5p

Well four out of the six funds saw gains over the week, with the UK Small Caps leading the way in the form of the Small Cap ETF and also the Herald investment trust. 

In contrast, the Japan ETF struggled this week as the Japanese yen strengthened, with continued doubts over the success of Prime Minister Abe’s “Abenomics” economic revival plan. I remain convinced that China should see better days ahead, and that this should have positive knock-on effects for the Japanese economy and stock market, which on certain profit-based valuation measures looks cheaper than it has for many, many years. 

This Week’s Articles, In Case You Missed Them…

I wrote a couple of articles on Gold and on Europe in my Mindful Money Expert Opinion column this week:

1. Focus on Gold Miners as gold glitters once again: Gold bugs have had a good start to 2o14, unlike those invested in stock markets. While the FTSE 100 index has lost 1% over the year to date, in contrast gold futures have gained over 7% in US dollar terms. Billionaire hedge fund manager John Paulson’s Gold Fund gained some 18% over the month of January, according to Institutional Investor Alpha. What are the best ways to play the gold rally? Click on the article to find out…

2. Buy Europe! The ECB will have to give the Euro economy a boost: Yes, I know that you may be hesitant to buy Continental European stock market exposure, given the travails of the Euro zone since 2008. And you would be right to object that the Euro zone sovereign crisis has by no means been definitively solved, with debt loads of countries such as Portugal, Spain and Italy still pretty enormous.

I am a firm believer that the European Central Bank (the ECB for short) will need to stimulate the Euro zone further in the months ahead, which should be unabashed good news for the European stock market.

There is also a video interview you can watch:

3. Bloomberg TV interview: Focusing on Euro corporate results. 

I invite you to cast your eyes over my Bloomberg TV appearance early (too early, at 6:10am!) this morning, commenting on corporate results from: Rio Tinto, BNP-Paribas, Commerzbank and Nestlé.

Have a great week ahead, and please don’t hesitate to recommend this newsletter to anyone who you know may be interested: to subscribe, please just email me at 

    idleinvestor@idleinvestor.com

The best of luck for the week ahead,

Edmund