Analysis indicates that smaller US company stocks providing strong returns as the markets rebound

Written by Ray Clancy

Wednesday, 28 July 2010 11:09

Smaller companies in the US are rebounding faster than larger ones as the country’s economy recovers, according to analysts.

An examination of performance data by Legg Mason affiliate Royce & Associates shows that US smaller companies stocks are providing strong returns for investors.

It comes as figures from the Investment Management Association show that the smaller Companies Sector delivered an average return of 43.6% over the year to 21 June 2010, whereas the North American Sector delivered 34.6% over the same timeframe. Over three years, the North American Smaller Companies sector returned 17.3% versus just 1.4% by the North American Sector.

‘Historical evidence shows smaller companies’ stocks historically provide strong returns as the market rebounds. According to our analysis, this pattern looks set to continue following the most recent downturn. What’s more the out performance also tends to endure for a number of years during the recovery so investors can still exploit the potential for out-performance in the small cap space,’ said Whitney George, Co-CIO of Royce & Associates and portfolio manager on the Legg Mason US Smaller Companies Fund.

Royce & Associates has been using a value approach to managing small and micro-cap stocks in the US for over 30 years. Through careful analysis of each company, Royce aims to ensure that the price it pays for a security is significantly below their appraisal of its current worth because of temporary or cyclical factors.

‘Compared with large caps, small caps are not overly cheap at present if traditional metrics such as price to earnings or price to book ratios are used. But the relief rally in the Russell 2000 from March 2009 was led by lower quality companies, such as non-earners, low return on equity generators and non-dividend payers. Companies with track records of high returns on invested capital, strong balance sheets and the ability to generate free cash flow can still be purchased at highly attractive valuations. We believe this will increasingly be a stock picker’s market, in which fundamentals and valuations are key,’ explained George.

George and co-portfolio manager Lauren Romeo, said they are currently finding good value in the financials, energy services, trucking and technology sectors while also seeing the stage set for increased M&A activity across the small cap universe as larger companies seek to consolidate their industry or enter new lines of business.

In their view, factors supporting this include stronger corporate balance sheets as a result of cash generation and de-leveraging by companies; improved access to debt and equity financing; the need for mature companies to find new revenue sources in the face of decelerating organic growth; pending changes in US capital gains tax laws that will spur business owners to sell before more onerous rates take effect in 2011; and the existence of around $500 billion of committed capital in private equity funds.