In times of confident bull markets (i.e. not the present) investors gravitate towards smaller, more volatile stocks, looking for "pure plays" that have significant operating leverage to improving fundamental drivers (e.g. the price of oil, interest rates, emerging market growth, etc.). Investors, like young men in a liquor store, seek to maximize the bang for their buck, and in doing so, they willingly take on more and more risk. In boom times, investors are quick to finance small companies that are billed as 'the next (insert successful company name)' or are being run by 'the former management team at so-and-so company' or 'provide significant exposure to a given commodity'. In essence, small capitalization companies (technically defined as having market caps between $250 million and $1 billion, while micro caps are smaller than $250 million) have greater leverage than large caps to a common set of business drivers. And when the market in general is rallying and money is easy to come by, this strategy works quite well and small caps tend to significantly outperform their larger cap brethren. But when the music stops, you better make sure you have a place to sit. While investor risk aversion tends to decline slowly over weeks and months, it can increase far more quickly, and more often than not, small cap stocks are the first to be sold when investors get jittery. Unfortunately, we've been knee-deep in jittery markets for the past year.

The deluge of negative forces faced by Canadian growth investors the past several months include sector rotation (see And the first one now will later be last, for the times they are a-changin' - Bob Dylan - July 25th), increased equity volatility (see "It will fluctuate" - JP Morgan, when asked what the stock market would do - August 1st), a stronger U.S. Dollar (see The Euro... making travel easier since 1999 - August 8th), and quietly, behind the scenes, a preference for large cap stocks over small caps. Let's delve a bit further into this large cap versus small cap situation, shall we? We've put together the chart below comparing the last 13 quarterly returns of Canada's TSX Venture Composite Index (a small-cap resource oriented index) to an equally weighted index of the TSX energy and materials sub-indices (i.e. large caps). The calculation that is being graphed is of the form, small cap return minus large cap return, so for quarters where small caps outperformed the bar graph is positive, and vice versa when small caps underperformed. We can see that small caps outperformed in the last two quarters of 2005 and first quarter of 2006 (sometimes by huge margins), while the two groups performed similarly over the balance of 2006 and the first quarter of 2007, but the tide turned last summer with the onset of the credit crisis, and small caps have underperformed markedly over each of the last 6 quarters. Perhaps most discouragingly, small caps only managed a small gain in the second quarter of 2008, despite a near 20% rally in large cap resource stocks.

All right, so what does this tell us about the investment universe? For starters, investors continue to act in a fairly risk-averse fashion, largely shunning small cap stocks. We would need to see at least one quarter of small cap outperformance before determining that much has changed on the risk-aversion front. Secondly, given the weak equity markets and tight credit markets, small cap companies are likely finding it harder (and/or more expensive) to raise financing in order to meet their stated growth targets. Finally, those small cap companies that are well-managed and performing operationally will be sucessful in the long-run but will likely see their share price depressed in the short-run... sounds like a pretty good time to be buying doesn't it? We think so, but let's just say this, as we search for the wheat we find ourselves sorting through a fair bit of chaff.

In other news...

Think you're under a lot of pressure at work? Try being arguably the most well-known Olympic athlete in a country that is hosting the Olympics and is eager to assert itself as the most successful nation, in terms of medal haul, at the Olympic games. Oh and just for good measure, you only compete in one event, and it only last about ten seconds. Such is the life of China's Liu Xiang. If you think Brett Favre's got some expectations to manage, that's nothing compared to the hopes and dreams pinned on Liu. There, now don't you feel a little better about your situation? We do.