Has 'the small company effect' in the UK had its day? A decade ago, when the Hoare Govett Smaller Companies (HGSC) index was launched it showed that, over the longer term, smaller companies had outperformed larger ones.

But now a report, published by ABN Amro Hoare Govett, undertaken by London Business School academics Elroy Dimson and Paul Marsh, looks at why the effect has since evaporated.

For 1987 and 1988 the HGSC index handsomely outperformed the market leaders" and smaller companies retained their premium in the marketplace. But the 1989 recession took its toll on the smaller sector. "The historical return premium on small companies of 6% has almost precisely reversed itself to become a return discount of 6%," says the report.

That level of superior return had persisted from 1955 to 1989. The study attributes the reason for this dramatic change not to a shift in market sentiment, but to a more basic cause. They emphatically rejects the notion expressed by some that the publication of the HGSC index was to blame. Critics claim that the publicity generated for 'the small company effect' caused small-caps to become over-bought until the bubble finally burst.

The reasoning will bring comfort to those who believe in fundamentals. The annual growth rate in real dividends in the years 1955-88 on the HGSC index was 3.3% a year, as against 1.5% for larger companies, the relative dividend growth being 1.8% in small companies' favour. But from 1989, the small company discount works out at -7.6% a year and their dividends declined at a rate 3.3% a year lower than for bigger companies.

This led to poorer stock market performance. The researchers say that the expectation of lower dividends resulted in the total returns difference being even greater than the differential in the dividend growth rate. Smaller companies were hit by this "double-whammy".

The same pattern can be found in the US, the researchers say, where since 1984, US small-caps have underperformed their larger peers by 4%, while dividend growth has been 2.7% a year lower than for the bigger companies.

From the continental European perspective, an analysis undertaken by done by London-based Style Investment Research Associates for IPE shows something of the same trend. The graph (fig 1) re-veals the relative returns of the smallest companies making up 20% of the market by market capitalisation - a total of 224 companies out of a total of 1,115 in Europe ex-UK.

"This shows an ongoing weak performance of small companies, despite a tentative rise during the middle of 1997," SIRA director Robert Schwob. Much the same results are found if the market is analysed according to the smallest 20%: within each industrial sector; within each market, or within each country specific industrial sector.

Looking at the question of small company performance in relation to superior earnings growth, Schwob says: "The returns to earnings graph (fig 2) shows that historic earnings growth is important and has been a positive signal to future share price performance over a reasonably long period - with some dips." In this graph the total number of securities covered is 963, and it required 489 to make 50% of the market by market capitalisation, which shows that on average small companies do not have higher than average growth. If they did, these smaller companies would have concentrated in the top half of the market (sorted by earnings growth) and it would have taken more than 489 companies to make up 50% of the total market capitalisation. Fennell Betson"