Saturday, April 22, 2006

A Shift To Small Caps

If we look at the senior employees of General Electric, Intel, Citigroup or Microsoft... they are a sober bunch. What a difference a few years make. The main difference being their sluggish stock options. In the 90s, they were making millions from stock options. However, its a bit mind boggling as these astute big caps are making good profits and even decent growth considering their size. What they couldn't understand is why their share prices haven't moved in tandem. The last 3 years have been "good not spectacular" for stocks in general, surely something must be amiss.

If we take the average 3 year return for big caps in the US, it registered a very decent 17% return a year. However when you compared that to small caps of US stocks, the figure is even better at 27%. What is even more shocking is the spectacular returns of international stocks (which can be termed as small to mid caps) of 32%. When you have these figures staring back at you, what has changed?

Investors are preferring smaller stocks, or rather they have more credible options than the safety of big blue chips. A big instigator for this movement is the rise and rise of hedge funds. Hedge funds need to extract higher returns, and to attack a big cap is ardous, lengthy and may need very sizable capital to effect "noise". A lot more hedge funds have replicated their operations in developing markets, as they are smaller in size and a rush of hedge funds onto their shores will have a multiplier effect on equity prices there. The higher the returns of small caps and international stocks, the more investors will be lured to move some of their holdings away from the safety of the big blue chips. What we will find for the next 2 years at least is the big blues paying their senior execs bigger bonuses, and much much less in share options.

Big blue chips have one thing going for them, most are sitting on very large cash holdings. Once the hedge funds and private equity buyout funds have finished with their pickings in international markets, they will refocus on the big blue chips - demanding for higher dividends, share buybacks and cancellation, or deploy the funds in a more meaningful manner. However that kind of task is generally drawn out, just look at Kerkorian and his battle with General Motors. Hedge funds don't have that kind of patience but private equity does. The main reason why there isn't a bigger shareholder revolt against big blue chips holdings so much cash is that equity returns in general have been more than decent over the past 3 years - once that starts to dip, the knives will be out.

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