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Can small cap indices score a hat-trick?

by Robert St George on Jan 29, 2014 at 08:51

For what it’s what worth, though, the NSCI entered the year trading on an earnings multiple of 19.5x, making it more expensive than the FTSE All Share on 16.3x.

In getting to these numbers, Marsh and Dimson exclude loss-making constituents, as Marsh argues that ‘you get some very silly answers’ if you try to incorporate them.

On their favoured measure, Marsh and Dimson are not overwhelmingly optimistic about 2014. At the start of January, the NSCI had a dividend yield of 2.3%, less than the FTSE All Share’s 3.3%.

Looking through their database on a straightforward single-year basis, Marsh and Dimson find a positive but weak correlation between a high starting yield and higher returns over the following year. They calculate that 12% of above-average returns could be attributed to an elevated initial yield.

The relationship is firmer over longer periods, however. Plotting cyclically adjusted five-year real yields against the following five years’ real return, Marsh and Dimson reported that 45% of better than average returns could be explained by a high starting yield.

The reason, they believe, is that high yields equate to low share prices; what the technique effectively indicates is that excess returns are likely to follow depressed markets.

So given the relatively low yield available at the moment, the duo concludes: ‘It is reasonable to expect small and mid cap investing to provide more modest rewards than they did in the past.’

Yet they add that the same is likely to be true of large caps as well, despite observing that the FTSE 100 has still to regain its peak of 6,930 in 1999 while smaller cap indices have already passed their record levels.

Marsh nonetheless emphasises that none of this should be taken to mean small caps are primed for a crash in 2014. ‘Don’t write off a third good year. That is perfectly plausible.’

The AIM conundrum

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