Short view By Philip Coggan - Financial Times

Short view
By Philip Coggan
Published: February 21 2006 02:00 | Last updated: February 21 2006 02:00 Copyright by the Financial Times

Growth or value? Large cap or small cap? Over the past five years, US investors who have plumped for the latter options have been rewarded.

So great has been the differential in performance that it has become an obvious contrarian call to opt for growth and large-cap stocks. That call did not work out in 2005, although the gap between small- and large-cap returns was rather smaller than it had been in previous years.

Inevitably, the performance differential has changed the fundamentals. Darrell Riley, who advises on asset allocation at fund management groupT Rowe Price, says small caps have gone from looking cheap relative to large caps in 2000 to looking expensive today. On a trailing price/earnings ratio basis, they now have a 40 per cent higher rating than stocks in the Russell 1000 (the gap is narrower if lossmaking companies are excluded).

Mr Riley says low borrowing costs have helped the small-cap sector, giving it the scope to expand into new areas. As a result, sales growth has been faster in the sector since 2003.

On the growth/value debate, Mr Riley points out that this has become increasingly about energy. The US energy sector earned a remarkable 29.1 per cent last year, in a remarkably flat market.

Given that energy has a13.6 per cent weight in the Russell 1000 value index and just a 3.6 per cent weight in Russell 1000 growth, this made a lot of difference to value's outperformance.

One reason why value has performed so well in stock market terms is that profits growth has been so strong. The last three months of 2005 delivered the fourteenth consecutive quarter of double digit earnings growth. When most companies are increasing their profits, there is no need for investors to pay a premium for growth stocks.

All this might change, however, if the economy starts to slow in the second-half of the year. If that happens, growth companies will stand out; furthermore, smaller companies would come under pressure.

But this might not be an outcome equity investors should wish for. If the economy does slow, bonds might easily outperform shares.