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.

16 Sep 2020

Why invest in small cap stocks?

  1. Attractive valuation vs larger cap stocks
  2. Potential for better longer-term returns
  3. Lower research coverage which gives well-resourced teams an information advantage, and opportunities to uncover hidden investment gems
  4. 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.

 

 

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

This chart shows the relative performance of the median manager against the benchmark for five years ending 30 June 2020. It compares the performance of small cap and large cap investment managers relative to their benchmarks in both the US and Europe. 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.

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.

Singapore Retail Investors

PLEASE READ THESE TERMS AND CONDITIONS CAREFULLY BEFORE PROCEEDING. BY UTILIZING THE WEBSITE AND PAGES THEREOF LOCATED AT WWW.UBS.COM/AM-SG ("WEBSITE"), YOU ACKNOWLEDGE THAT YOU HAVE READ THESE TERMS AS WELL AS THE GLOBAL TERMS OF USE (collectively "TERMS") AND THAT YOU AGREE TO BE BOUND BY THEM. IF YOU DO NOT AGREE TO ALL OF THE TERMS OF THIS AGREEMENT, YOU ARE NOT AN AUTHORIZED USER OF THESE SERVICES AND YOU SHOULD NOT USE THIS WEBSITE.

This website is not intended for and should not be accessed by persons located or resident in any jurisdiction where (by reason of that person's nationality, domicile, residence or otherwise) the publication or availability of this website is prohibited or contrary to local law or regulation or would subject any UBS entity to any registration or licensing requirements in such jurisdictions. It is your responsibility to be aware of, to obtain all relevant regulatory approvals, licenses, verifications and/or registrations under, and to observe all applicable laws and regulations of any relevant jurisdiction in connection with your entrance to this website. Each investment product and service referred to on this website is intended to be made available only to residents in Singapore.

UBS reserves the right to change, modify, add or remove content on the website as well as these terms at any time for any reason without notice. Such changes shall be effective immediately upon posting. You acknowledge that by accessing our website after we have posted changes to these terms, you are agreeing to these terms as modified.

The materials on this Website are distributed by UBS Asset Management (Singapore) Ltd (company registration number: 199308367C), which is licensed by Monetary Authority of Singapore ("MAS") in Singapore pursuant to the Securities and Futures Act (Chapter 289 of Singapore). UBS Asset Management (Singapore) Ltd is part of the Asset Management business division of UBS Group AG. UBS Asset Management (Singapore) Ltd together with UBS Group AG and its group companies shall collectively be referred to as "UBS".

The information contained in this Website has been prepared and is intended for general circulation. The information does not constitute advice and does not take into account the specific investment objectives, financial situation, or particular needs of any particular person. The investment services or products referred to in this Website may not be suitable for all investors. UBS recommends that you independently evaluate particular investments and strategies and seek independent advice from a financial adviser regarding the suitability of such investment products, taking into account your specific investment objectives, financial situation and particular needs, before making a commitment to purchase any investment products. Investment involves risks. You should be aware that investments may increase or decrease in value and that past performance is not indicative of future performance.

The information contained in this Website is not an offer to buy or sell or the solicitation of an offer to buy or sell any investment product or to participate in any particular trading strategy. UBS, its officers and/or employees may have interests in any of the investment products referred to on this Website by acting in various roles. UBS, its officers and/or employees may receive fees, commissions or other benefits for acting in those capacities. In addition, UBS, its officers and/or employees may buy or sell investment products as principal or agent and may effect transactions which are not consistent with the information set out in this Website.

You fully understand and agree that, by making available this Website, UBS should not be construed as making: (a) any endorsement of any investment product referred to in this Website; (b) any representation that UBS has performed any due diligence on any investment product referred to in this Website; or (c) any representation that the information in this Website is complete, accurate, clear, fair and not misleading. The use or reliance on any such information contained in this Website is at your own risk and any losses which may be suffered as a result of you entering into any investment are for your account and UBS shall not be liable for any losses arising from or incurred by you in connection therewith. UBS is not responsible or liable for the accuracy and completeness of any such information or the performance or outcome of any investment made by you after receipt of such information, irrespective of whether such information was provided at your request.

Using, copying, redistributing or republishing any part of this Website without prior written permission from UBS is prohibited. Any statements made regarding investment performance objectives, risk and/or return targets shall not constitute a representation or warranty that such objectives or expectations will be achieved or risks are fully disclosed. The information and opinions contained in this Website is based upon information obtained from sources believed to be reliable and in good faith but no responsibility is accepted for any misrepresentation, errors or omissions. All such information and opinions are subject to change without notice. A number of comments in this Website are based on current expectations and are considered “forward-looking statements”. Actual future results may prove to be different from expectations and any unforeseen risk or event may arise in the future. The opinions expressed are a reflection of UBS’s judgment at the time this document is compiled and any obligation to update or alter forward-looking statements as a result of new information, future events, or otherwise is disclaimed.

UBS does not hold out any of its officers and/or employees as having any authority to advise you, and UBS does not purport to advise you on any investment product. Any investment will be made at your sole risk and UBS is not and shall not, in any manner, be liable or responsible for the consequences of any investment.

This Website and its contents are provided on an “as is” and “as available” basis. UBS does not warrant: (a) the accuracy, timeliness, adequacy commercial value or completeness of this Website or its contents, and expressly disclaims any liability for errors, delays or omissions in the contents, or for any action taken in reliance on the contents; (b) that your use of and/or access to this Website or its contents, will be uninterrupted, timely, secure or free from errors or that any identified defect will be corrected; (c) that this Website or any content will meet your requirements or are free from any virus or other malicious, destructive or corrupting code, agent, program or macros; (d) that any information, instructions or communications posted or transmitted by you through this Website is secure and cannot be accessed by unauthorised third parties; and (e) that use of the contents in this Website by you will not infringe the rights of any third parties. No warranty of any kind, implied, express or statutory, including but not limited to the warranties of non-infringement of third party rights, title, merchantability, satisfactory quality or fitness for a particular purpose and freedom from computer virus or other malicious, destructive or corrupting code, agent, program or macros, is given in conjunction with this Website.

You hereby agree to indemnify UBS and any of its officers, employees or agents against, and to keep UBS and any of its officers, employees or agents harmless from, any claims (actual and threatened), settlement sums, liability, loss, damages, costs (including solicitor and client costs and expenses (legal or otherwise)), charges, expenses, actions, proceedings, whether foreseeable or not which we may sustain, suffer or incur, directly or indirectly out of or in the course of or in connection with any the following: (a) any use of this Website or the contents by you, or any part thereof; (b) UBS having made available the Website; (c) any breach of these Terms by you, however arising; or (d) any negligence, act or omission, wilful default, unlawful act, fraud and/or misconduct on your part or violation of any rights of another person or entity by you.

The funds referred to in this Website have been authorised or recognised by the MAS for sale to the public in Singapore (the “Funds”). Copies of the registered Singapore prospectuses ("Prospectuses") referred to in this Website have been lodged with and registered by the MAS. The MAS assumes no responsibility for the contents of the Prospectuses. The registration of the Prospectuses by the MAS does not imply that the SFA or any other legal or regulatory requirements have been complied with.

MAS registration is not a recommendation or endorsement of a Fund nor does it guarantee the commercial merits or performance of such Fund. It does not mean that a Fund is suitable for all investors nor is it an endorsement of its suitability for any particular investor or class of investors. UBS Asset Management (Singapore) Ltd has been appointed as the representative for the Funds in Singapore for the purposes of performing administrative and other related functions relating to the offer of Shares under Section 287 of the Securities and Futures Act, Chapter 289 of Singapore (the "SFA") and such other functions as the MAS may prescribe.

You may not assign your rights under the Terms without our prior written consent. UBS Asset Management (Singapore) Ltd may assign our rights under the Terms to any third party.

No person or entity who is not a party to the Terms shall have any right under the Contracts (Rights of Third Parties) Act, Chapter 53B of Singapore or other similar laws to enforce any term of the Terms regardless of whether such person or entity has been identified by name, as a member of a class or as answering a particular description. For the avoidance of doubt, this shall not affect the rights of any permitted assignee or transferee of the Terms.

These Terms shall be governed by, and shall be construed in accordance with, the laws of Singapore. The courts of Singapore shall have exclusive jurisdiction to hear and determine any suit, action or proceeding, and to settle any disputes, which may arise out of or in connection with these Terms and, for such purposes, you agree to submit  to the jurisdiction of the courts of Singapore. Each party hereby waives any objection which it might at any time have to the courts of Singapore being nominated as the forum to hear and determine any proceedings and to settle any disputes and agrees not to claim that the courts of Singapore are not a convenient or appropriate forum.

© UBS 2020 - the key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved.

Reset

Latest equity insights