4 reasons to invest in small cap stocks
Over the long-term, small cap stocks could deliver higher returns. And now is a good time for investors to consider these companies as valuation is attractive.
Why invest in small cap stocks?
- Attractive valuation vs larger cap stocks
- Potential for better longer-term returns
- Lower research coverage which gives well-resourced teams an information advantage, and opportunities to uncover hidden investment gems
- Broader investment set, higher active share, larger chance of outperformance for active managers
The Coronavirus pandemic has had a profound effect on share prices this year, and smaller companies have been no exception. In the first seven months of 2020, the MSCI All Country World Small Cap index (ACWI Small Cap) fell by 8.7%, against the 1.3% drop of the MSCI All Country World Index (ACWI) . Small cap stocks typically deliver higher long-term returns, and we explore why we believe that now is a good time for investors to consider their allocations to small cap.
Small cap investing 4 reasons to invest in small cap stocks
Small cap stocks are currently trading at a significant discount of 1.6x Price to Book (P/B) ratio vs 2.4x for large cap companies. We believe this could provide a more attractive entry point for investors.
The PB ratio is a better valuation guide as book value is more stable in a period where earnings have been severely impaired by the global pandemic.
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| Div yield % | Div yield % | P/E (x) | P/E (x) | Fwd P/E (x) | Fwd P/E (x) | P/B | P/B |
|---|---|---|---|---|---|---|---|---|---|
| MSCI ACWI Small Cap | Div yield % | 1.9 | P/E (x) | 24.9 | Fwd P/E (x) | 23.3 | P/B | 1.6 |
| MSCI ACWI | Div yield % | 2.1 | P/E (x) | 20.9 | Fwd P/E (x) | 19.7 | P/B | 2.4 |
There have been many academic studies conducted on the 'size effect' over the past 40 years. Pioneering work by economist Rolf Banz published in 19812 looked at the size effect across US stocks. This was soon followed by the seminal work by Fama and French in 19923 as they introduced their 'three factor model' that explored the performance of the size effect across Value and Growth segments.
The academic research has been supported by the performance of small cap indices over the long term. As the chart below shows, the small cap premium, which is the difference in returns between small caps and the broader market, is 2.4% for the last 20 years.
Performance of smaller companies has historically been better over the long term
Index performance – gross returns (%) (Jul 31, 2020)
Index | Index | 1 month | 1 month | 3 months | 3 months | YTD | YTD | 1 year | 1 year | 3 years | 3 years | 10 years | 10 years | 20 years | 20 years |
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
Index | MSCI ACWI Small Cap | 1 month | 4.50 | 3 months | 15.06 | YTD | -8.71 | 1 year | -1.24 | 3 years | 2.54 | 10 years | 8.73 | 20 years | 7.73 |
Index | MSCI ACWI | 1 month | 5.33 | 3 months | 13.54 | YTD | -0.98 | 1 year | 7.76 | 3 years | 7.56 | 10 years | 9.45 | 20 years | 5.29 |
The size of free float of small companies means it is generally uneconomic for stockbrokers and investment banks to commit resources to analyzing them. For European equities by market cap -- there is a precipitous decline in the number of sell-side analysts covering smaller stocks (See Figure 1 in the full paper). We see the same effect in other regions. The lack of coverage of small cap stocks may also have been impacted by the introduction of MiFID II in Europe, which has driven an even greater focus on the economics of research. We believe this relative lack of information is one of the key reasons for the greater level of small cap market inefficiency. It could provide well-resourced portfolio management teams with a substantial information advantage, in turn enabling them to identify strong investment opportunities.
One of the key tenets of investment management is that outperformance is a function of manager's skill combined with the breadth of investment opportunities. Assuming a consistent level of manager skill, small cap managers should perform better and provide a higher degree of alpha than managers of large cap portfolios due to their broader investment set. Thus experienced small cap investors may be more likely to avoid companies in structural decline and find companies exposed to fast growing areas, such as e-commerce and educational services.
Small cap indices are less concentrated than large cap indices, with the largest 10 stocks in the MSCI Small Cap Index accounting for only 1.8% of the index's total market cap, while the top 10 companies in the MSCI World Index account for 16.6%. This means that small cap managers typically have a higher active share than large cap managers. This higher differential provides greater potential for alpha generation.
Relative performance of the median manager against benchmark for five-year period ending 30 June 2020
Comparing the performance of small cap and large cap investment managers relative to their benchmarks in both the US and Europe (see chart), we see that over the past five years the median small cap manager outperformed their benchmark by 2% in Europe and 0.85% in the US, while the median large cap manager outperformed their benchmark by 1.45% in Europe and underperformed by -0.6% in the US.
Hence, adding better manager performance to higher overall returns increases the return that small cap investors may realize over the long term.
One reason for the better returns may well be the difference in complexity in analyzing stocks. Smaller companies tend to have a narrower, more focused range of business activities than their larger peers and are therefore generally easier to analyze. By contrast, GE for example has 205,000 employees across hundreds of businesses, ranging from health care to energy to jet engines. Developing a deep understanding of the dynamics of a company of such scale is a mammoth task requiring knowledge across multiple sectors.
In contrast, smaller companies tend to operate with fewer, or often single business lines, making the task for an analyst that much easier. While this may not necessarily mean they perform better, it does mean investors seeking to generate alpha from choosing one company over another can feel greater confidence in understanding the dynamics of the business, and therefore hold a higher active share.
Small cap investing Potential pitfalls to watch for
Small cap stocks tend to be more cyclical and domestically-focused, in contrast to the larger multi-nationals that dominate large cap indices. The sector breakdown in the table below shows the difference in weightings between the MSCI ACWI and the MSCI ACWI Small Cap.
Sector | Sector | MSCI ACWI % | MSCI ACWI % | MSCI ACWI Small Cap % | MSCI ACWI Small Cap % |
|---|---|---|---|---|---|
Sector | Communication Services | MSCI ACWI % | 9.44 | MSCI ACWI Small Cap % | 3.39 |
Sector | Consumer Discretionary | MSCI ACWI % | 12.1 | MSCI ACWI Small Cap % | 12.9 |
Sector | Consumer Staples | MSCI ACWI % | 8.1 | MSCI ACWI Small Cap % | 4.89 |
Sector | Energy | MSCI ACWI % | 3.3 | MSCI ACWI Small Cap % | 2.44 |
Sector | Financials | MSCI ACWI % | 13.05 | MSCI ACWI Small Cap % | 11.73 |
Sector | Healthcare | MSCI ACWI % | 12.8 | MSCI ACWI Small Cap % | 12.57 |
Sector | Industrials | MSCI ACWI % | 9.26 | MSCI ACWI Small Cap % | 16.82 |
Sector | Information Technology | MSCI ACWI % | 21.1 | MSCI ACWI Small Cap % | 14.94 |
Sector | Materials | MSCI ACWI % | 4.76 | MSCI ACWI Small Cap % | 7.54 |
Sector | Real Estate | MSCI ACWI % | 2.85 | MSCI ACWI Small Cap % | 9.87 |
Sector | Utilities | MSCI ACWI % | 3.24 | MSCI ACWI Small Cap % | 2.91 |
The structure of indices by sector can clearly make a difference to long-term performance. Small cap indices are typically more cyclical with more Materials and Industrials stocks, while large cap indices have more in Information Technology and Communication Services. This is especially the case in the US where the mega caps have dominated performance over the past few years, and this sector differential will remain a key driver for relative performance going forward.
Small cap stocks also typically have a higher beta, so when the market goes down they usually suffer more, and this was seen clearly during the downturn in the first half of 2020, as shown in Figure 5. This was largely driven by the underperformance of US small cap stocks, while Europe's small caps actually performed relatively well. This greater cyclicality has been a negative in 2020, but on a longer-term basis the higher cyclicality and beta is a positive for delivering better returns.
Small caps tend to have fewer choices in credit markets and might have to pay a higher yield premium to compensate debt investors for increased levels of risk. As a consequence, small caps are more dependent on bank loans for financing, which can be problematic during environments of tighter credit control. The number of defaults and bankruptcies is higher due to lower diversification and companies will often be at the mercy of one main bank rather than syndicates, increasing the financial risk. Small cap companies are often more leveraged than larger caps, which provides higher risk, but also greater leverage to economic upside.
Environmental, social and governance (ESG) issues are of increasing importance to investors and data for smaller companies can often be more difficult to access due to the relatively low coverage of these companies by data providers. Smaller companies are sometimes controlled by a founding family or by management shareholders. While this may align financial interests, it usually implies a lower level of independent oversight. Also of interest is the size of boards. Large companies, due to the complexity of the business, usually have large boards. For smaller companies, boards tend to be less diverse. The cost of employing numerous non-executive directors is often a cost smaller companies are not willing to pay, so there is generally a lower level of oversight and scrutiny. What is clear is that corporate governance for smaller companies is more variable, and investors need to pay much closer attention to the management of the business.
Small companies also may not have the same degree of resources in developing environmental, social and governance policies due to the relative cost.
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