30 October 1999

Was it all a false dawn? Again? Smaller company stocks seemed finally to be regaining their stride this year but their good run has petered out.

The FTSE SmallCap index outperformed the FTSE 100 by more than 31 per cent between the start of January and mid-September but has underperformed the blue chip index by 8 per cent since then.

Moreover, this year's rally has regained only some of the ground that smaller companies have lost this decade. The fact is that the SmallCap has underperformed the Footsie by more than 40 per cent since the start of 1989.

The key problem for smaller stocks in the past month or so has been the make-up of the sector. The SmallCap is weighted much more heavily in manufacturing stocks than the FTSE 100, which has heavy weightings in the likes of banks, telecommunications, oils and pharmaceuticals.

The manufacturing sector performed very well in the first half of the year as it became clear that the UK economy was going to avoid recession and turn in decent growth. But the tide turned in September when the Bank of England raised interest rates by a quarter of a point. Not only did it become clear that further rate rises were likely but the pound shot up on the shift in policy, making life more difficult for exporters.

Thus, although the latest Confederation of British Industry survey painted a distinctly upbeat picture of manufacturing sentiment, investors have taken a less sanguine view. General industrial stocks have underperformed the Footsie by 10 per cent since the start of September; engineering stocks have lagged behind the blue chips by more than 16 per cent.

Investors have turned back to the reliable growth stocks, the companies that are guaranteed to produce profit increases whatever the economic circumstances. Telecommunications and pharmaceuticals, little represented in the SmallCap index, have started to outperform again.

Until it becomes clear that UK interest rates are close to their peak, it is hard to see this situation reversing itself; small company stocks may face an uphill struggle.

Still, at least some smaller stocks have brought investors bumper returns this year. Imagination Technologies (the old Videologic) has more than trebled in price while Biocompatibles (which makes coatings for medical devices) and Albert Fisher, the food group, have nearly done so.

Moreover, a long list of companies - including retailer Brown & Jackson, software group Kewill Systems and Scotia Holdings, a pharmaceuticals business - have more than doubled.

One or two of these are the penny shares beloved by stock market tipsters but, in fact, some even better returns could have been achieved further up the market capitalisation scale. Three stocks that have quadrupled so far this year are all in the FTSE 250 index: chip company ARM, computer games group Eidos and Photo-Me International, a photo booth group.

The first two are part of the UK's growing technology first division which, while still not in the league of the Microsofts and Intels, at least offers investors a choice of substantial plays on the high-tech boom.

Be careful, however, if you are drawn towards the new techMARK indices produced by FTSE International and linked to the stock exchange's new technology forum. There are two indices: the Techmark All-Share and the Techmark 100. The problem with the former is that the exchange decided to draw the net very widely when deciding which stocks would qualify for Techmark.

As a result, more than two-thirds of the All-Share is made up by just eight stocks that most people would not regard as high-tech specialists: Vodafone Airtouch, BT Glaxo Wellcome, AstraZeneca, SmithKline Beecham, Cable & Wireless, GEC and Orange.

The Techmark 100 is a much purer play on the sector. ARM, for example, is 5 per cent of it but only 0.8 per cent of the All-Share index. Fortunately, Close Fund Management's tracking fund, to be launched next week, is linked to the Techmark 100, not the All-Share.

Meanwhile, the overall London market rebounded strongly at the end of the week, aided by US economic data that pointed to still restrained inflationary pressures.

To the casual observer, the good news was fairly limited; the employment costs index was up 0.8 per cent on the quarter, compared with the consensus forecast of 0.9 per cent, while the prices paid component of the Chicago purchasing managers' index was 65. That was down from 71 last time but still points to rising prices.

Clearly, the US equity and bond markets had got overly nervous about the potential for rate rises and seized on the data as an excuse to buy.

The UK followed Wall Street higher, even though it has its own problems. A Reuters poll found that 25 of 33 analysts expect interest rates to rise next week when the Bank's monetary policy committee (MPC) meets.

Richard Jeffrey, the hawkish economist at CCF Charterhouse, argues that the MPC should raise rates by half a percentage point. He notes, also, that "until investors have a clearer idea of the likely peak in UK rates, the downside risk in share prices will remain significantly greater than the upside potential".

Trevor Greetham, global strategist at Merrill Lynch, says, "We are in a bear market, but one that will zigzag." He argues that the US and UK are in the part of the economic cycle where interest rates are rising and cash outperforms bonds and equities.