When a recession looms and the bears head for the exits, small-cap stocks usually get trampled first. But when good times return, they often lead the way back: Small-cap shares almost always outperform blue chips in the first year after a downturn. And with the global economy on the mend, the small-is-beautiful pattern is holding up, particularly in Japan, South Korea, Taiwan, and Western Europe. Small caps "tend to be nimbler and to respond more quickly to an economic upswing," says Charles Hall, head of small-cap research at WestLB Panmure in London. "We think they will continue to outperform for the rest of this year."
Global investors looking at small-caps are sizing up companies with market capitalizations between $300 million and $1 billion and endowed with strong managers, a distinct market niche, and robust cash flow. In Japan, for instance, small caps "tend to be of a better quality and more focused" than big companies that are saddled with too much debt and money-losing subsidiaries, says Garry Evans, an equity strategist at HSBC Securities Inc. They're cheaper, too. In Asia and Western Europe, the average 2002 price-equity ratio for small-caps is 15, vs. 20 for the big, listed companies, according to Schroders Investment Management in Singapore.
No country has seen more explosive growth in small-cap values than South Korea, where the overall market has vaulted 90% since its low point after September 11. Although the rally has lifted all boats, some small caps such as Humax Co. and NCSoft have seen their share price triple. Kim Sung Dae, head of equity investment at Korea Investment Trust Co., likes Humax, which makes TV set-top boxes for receiving satellite broadcast services. With a thriving export business in Europe, Humax' earnings are expected to jump 30% this year, to $80 million, on revenues of $370 million. Kim also likes PC- game designer NCSoft, which is clocking 20% profit growth this year. Its Lineage online fantasy game is a smash hit in tech-happy South Korea.
Small and midsize high-tech players are shining in Taiwan, particularly those focused on wireless technologies and consumer electronics. Since High Tech Computer Corp., which makes pocket personal computers for Compaq Computer Corp. and others, listed its shares in Taipei on Mar. 26, its stock has jumped 50%. Another favorite is camera maker Premier Image Technology Corp., a manufacturer of high-end digital cameras. Its profits are expected to jump 25% this year.
In Japan, the Jasdaq over-the-counter market is up 5.1% this year, while the overall market has risen 4.4%. Consumer spending is tight, but innovative retailers are worth a look, says HSBC retail analyst Mariko Watanabe. She has buy recommendations on Toys `R' Us Japan, which just added nine stores, and Shidax Foodservice Corp., a company that also runs karaoke bars. She forecasts double-digit gains for both stocks this year.
In Europe, small-caps outperformed the market by 3.5% in the first quarter. And it's not just the economic recovery that's helping them, says Claudia Rathgeb, a fund manager at DWS Investments in Frankfurt. Small-caps are getting a boost from the euro, which has created a pan-European market for small-caps, and the trend toward economic liberalization, which frees small companies to compete more effectively.
It is the traditional cyclical stocks--construction, chemicals, and utilities, for example--that are now doing the best in Europe. Take Kier Group, a London-listed diversified construction outfit that operates mainly in Britain. Its order book is up 20% from a year ago, and its share price has jumped more than 15% since Jan. 1. A Novo, a French company that provides support services for electronic-payment, videoconferencing, and IT companies, saw a 49.8% surge in first-quarter sales compared with a year earlier, and Schroder Salomon Smith Barney expects its stock to outperform the market strongly this year. The shares of German database-management company Software AG should also do well this year, overcoming a recent profit warning and its dismal recent share performance, says Schroder Salomon Smith Barney. Its new chief financial officer is committed to cutting costs, and the company has recently launched new products that should boost its revenue as economic growth takes hold and demand increases.
Add it all up, and once again small-caps are wasting no time picking themselves up off the mat as the recession fades.
By Brian Bremner in Tokyo, with Moon Ihlwan in Seoul, Bruce Einhorn in Hong Kong, and David Fairlamb in Frankfurt
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