What Awaits Small-caps in 2010?

“The Financial World According to Inya” Column,
by Inya Ivkovic, MA

During its recent committee meeting, the Federal Reserve announced that it is time to shut off the government money taps, winding up most of the U.S. specialty liquidity programs and starting by shutting down currency swaps with most foreign central banks by February 1, 2010. At the time, the Fed did not even address the risk of inflation or hyperinflation in the short term. Thus, the expectation is that interest rates will remain at ultra-low levels close to zero for at least the first half of 2010, if not longer. Eventually, however, interest rates will have to go up if the economy finally starts growing at a faster pace.

That said, if the Fed effectively manages to shift gears at the end of January towards restrictive monetary environment, some economists expect that the U.S. GDP will register output between four percent and 4.5% next year. If that pans out — and we have some misgivings about such an overly optimistic forecast and having the mess in the labor market in mind — then the overwhelming advice would be to load up on small-caps.

In essence, lining up investors’ exposure to small-caps along the changes in business cycles usually means increasing holdings in small-caps during economic recovery times and restricting exposure during times of restrictive monetary policy. For true diversifiers across all asset classes, the exposure to small-caps should never be zero. Quite the contrary, in the next three to six months, it might be a good idea to increase exposure to small-caps in one’s portfolio.

But let us be clear on something. Investing in small-caps is risky mainly because it is quite an unpredictable asset class, despite numerous key factors potentially working to its advantage. If the third-quarter earnings and revenues are of any indication, each declining by 28% and 15%, respectively, small-caps could actually lag large-caps early in the New Year.

Another opinion shared by many economists is that large-caps will outperform small-caps in 2010, because the former group has greater exposure to international markets, which have recuperated much faster than the U.S. economy, while small companies are more involved in the domestic markets. Overall, this is true. However, we believe there are plenty of small-caps that also have exposure to foreign markets, although not on the same scale as large-caps. We do not expect exposure to foreign markets to be a huge factor for small-caps in the coming months. We believe what will make the difference are companies with an edge, those developing exciting proprietary technologies, operating in niche markets, growing fast and generating strong earnings. The third quarter of this year was a difficult one for small-caps, but the Russell 2000 Index has posted gains against the S&P 500 Index again in October and November. In our books, this is grounds for optimism about small-caps’ prospects in the New Year.

Another significant disadvantage that may adversely impact performance of small-caps in 2010 is their tendency to weigh more heavily in the financial and consumer discretionary sectors, both of which are not expected to offer stellar performances in the first quarter of next year. However, if solid economic data continue pushing through, the initial lag of those two sectors may be a short one. That being the case, larger pools of money, such as pension funds, may deem it appropriate to take additional risks in exchange for the returns that small-caps may offer next year.

When performing due diligence on small-caps, investors should pay close attention to what is going on in the credit markets, too. Credit spreads between high yield bonds and U.S. Treasuries have declined from 22% about a year ago to about 7.5%. However, the credit market specialists generally do not expect the spreads to keep on declining much further and that could spell trouble for small-caps.

Credit spreads are a useful gauge to determine the economy’s lending capacity. Generally speaking, it is difficult for small-caps to raise cash through equity or bond offerings. What happens more often is that small-caps have to go to the bank to get the money needed to fund their operations. So, if the credit is not readily available or if loans are offered at difficult terms, small-caps may find themselves in the unenviable situation of being operationally stuck and unable to move forward. This is where small-caps with strong balance sheets have a distinctive advantage over their counterparts burdened with debt and declining cash flows from operations.

As far as Lombardi Financial is concerned, there is no such thing as a bad time to buy small-caps. We like them, because small companies are innovative and proactive and are a vital part of the large engine driving the economy out of the downturn. This is why, even when the credit markets are tight, small-caps have no shortage of private investors looking for new ideas and places to put their money to good work.