The Effect of Recession on Small Cap Stocks - August 6th 2010
Written by guest contributor Jennifer Gorton from Forex Traders
No businessman likes the word recession. It’s a curse word of sorts among entrepreneurs. However, it is a fact of life and a regularly occurring phenomenon in our current global economic system. The effect of a recession upon a company’s growth can vary. In fact, there are certain industries that tend to outperform during times of recession, and these companies can actually benefit from an economic downturn. This is however an exception and not the rule. The overwhelming majority of companies are negatively affected during economic downturns, and small cap businesses are a specific segment that often get hit hard.
A small cap company is generally classified as a company with a market capitalization of under $500 million. Thus, these companies are not necessarily your mom and pop shop on the corner, but in the business world, they are still considered small. Many stock investors specialize in trading small cap stocks because they generally offer the highest growth potential that exists in this market. Companies that are blue-chip, or large cap, will most likely not be able to grow at the same rate that these smaller companies are able to grow. Oftentimes, small cap companies are launching a new product or seeking to expand beyond a certain region, and the growth potential is high. In order for most small cap companies to succeed in a product launch or border expansion, an accommodative economy is generally essential. If the economy is in a downturn, two primary negative effects immediately weigh on small cap companies.
The current economic downturn over the last two years is a perfect example of how credit tightens during a recession. The Bank of Canada and Federal Reserve will of course do all that it can to stimulate economic activity and lending, but it cannot force banks to lend. During the last two years, banks have been very hesitant to lend due to the massive write-downs they have already experienced. Thus, tight credit and very difficult lending standards have made it difficult for small cap companies to grow. Oftentimes significant credit is needed in order to successfully launch new products and expand into new areas. When that credit dries up, small cap companies get stuck in the middle of operations, which is one of the worst things that can happen to a business. If everything is lined up for a new product launch, but credit markets freeze, a potentially profitable situation can quickly turn sour. This phenomena will often scare investors and cause a depreciation of the company’s stock which weighs further on company growth. A lack of ready credit can literally set off a series of events that cause real damage to small cap companies.
Cashflow is said to be the lifeline of a company. With it, business continues normally. Without it, operations freeze and during a recession, cash is king. Economic downturns cause big losses and big losses tend to eat up cash reserves, especially those exposed to risky currencies in the Forex market. Cashflow is also heavily connected to credit operations. If a company cannot get the credit it is used to getting from a bank, then it is forced to rely on cash reserves. However, if cash is not steadily coming in to the business in the form of payment from revenue, then cash reserves will generally dissipate quickly. And the very real probability during an economic downturn is that revenue will dry up. If a company is attacked by a combination of tight credit and decreasing revenue, a cash flow crisis could erupt. In this situation, payroll may not be met, bills may not be paid, and a company may ultimately face bankruptcy. This threat of weak cashflow during a recession is a real problem for small cap companies. Although very solid companies with strong management and leadership will generally be prepared for these circumstances, this is not always the case in the majority of companies. In hopes of rapid company growth and increased market share, many small cap companies will over leverage and extend themselves; therefore, when an economic downturn does come and cashflow does dry up, these companies face major obstacles, with the ultimate defeat of possible bankruptcy.
Understanding these two major risks facing small cap companies during a recession can help investors better choose small cap companies to invest in. Since these are major concerns during a recession, one step of small cap stock analysis should be to determine how well companies have handled previous recessions in terms of still accessing credit and maintaining cash reserves. If a company has struggled significantly in previous economic downturns, an investment may not be the best idea. This is also why it is so imperative to do full due-diligence on the credit worthiness of a potential small cap investment. Large debts and irresponsible fiscal positions will undoubtedly weigh heavily on small cap companies in a recession.