When many overseas investors see an economic recovery coming they rotate part of their portfolio out of blue chips into small caps.  The reason for this behaviour is that smaller companies tend to be more geared to the local economy and, growing from a smaller base, stand to gain more when things are going well.

This goes both ways too, as overseas small caps tend to lead overseas stock market crashes with money flowing out of the stock market and into more "robust" blue chip shares (the "flight to quality" phenomenon).

Whilst the above is a simplification of what is sometime referred to as the "small-cap cycle", in my opinion this theory does not perfectly fit our local small-cap landscape.

To understand the market, you must understand the market participants, as the market is simply the aggregation of all its participants' decisions.

Thus it is imperative to understand that the same overseas investors that would invest in US or UK small caps at the start of a recovering economy would-for the same reasons-also choose to rotate into emerging markets.  This decision is often less of what the investor is buying, but more of where is.

Thus, when a recovery is seen in the global economy, our blue chips and some of the bigger mid caps are the first to recover with net foreign investor capital inflows.  Our local small caps only begin to follow the market upwards after the local blue chip valuations become strained and bloated.

In other words, our local small caps not only do not precede the market recovery, but in fact lag it.  This local phenomenon I have termed the "Local Lagging Effect on Small Caps" (or "LLESC" for short).

Refer to the graph where the five year index history of the AltX (black line) is compared to that of the JSE AllShare (blue line).

(Click image for larger picture.)

(Source: https://securities.standardbank.co.za/)

Notice how during mid-2007 (period "A") the AllShare was leading the AltX's direction upwards with the latter possibly lagging its boom at points.

Then the "LLESC effect" kicked in, blue chip valuations began looking strained, capital began seeking pockets of value and pushed the AltX into super-returns territory (period "B") attracted "risk-seeking behaviour".  This demand brought about a listing boom that peeked at the beginning to middle of 2008.

Following this peak the AltX began quickly declining in a credit crunch-induced bear market to where the AltX is currently below the AllShare (period "C").

Notice how recently (period "C") the AltX has continued its decline, while the AllShare actually risen?

Based off this simplified observation and the LLESC effect I've discussed above, it implies that the AltX and small caps in general are in a good position to begin rotating a portion of your portfolio into.  Over the next six months to a year or so they should stage a strong comeback to catch-up with the AllShare.

In conclusion, currently the long-term investor stands to be handsomely rewarded from beginning a careful rotation of part of their portfolio into a number of fundamentally sound and under-valued small caps.  This will not only have the potential of bringing alpha to their portfolio, but could also lower its risk through the lagging correlation of small caps to the overall market.

---