All good things come in small packages

Ian Gamon

Partner

The bottom line:

Small cap equities are an underappreciated asset class with several compelling advantages for patient investors. 2023 shows signs of being a good point to enter this market.

Over 6,000 publicly listed companies representing USD 8 trillion (c.14%) of global market capitalisation are categorised as smaller companies and fall outside the traditional equity indices of most investors. This is a missed opportunity for many institutional, long-term investors who typically benchmark their global equities against those traditional equity indices like MSCI World and MSCI ACWI.

Institutional investors, particularly those in Europe, tend to have low allocations to smaller companies. Research reported by IR Magazine in December 2021 highlighted that less than half of shares in smaller companies are held by institutional investors in contrast to 66% of shares in large companies. Instead, public shareholdings in smaller companies tend to be dominated by retail investors.

Investing in smaller companies – usually referred to as “small cap investing” – targets publicly listed companies with market capitalisations typically ranging from USD 200m to USD 2bn. Despite the name, these companies are often well-known businesses with long-established markets. For example, in the UK, companies such as:

Halfords, the car parts to bicycles retailer;
Kier Group, the construction and infrastructure business; or
Wincanton, the logistics and distribution company.

In practice, so-called small cap investment funds often include “mid-cap” companies which have market capitalisations up to USD 10bn but which typically fall outside the broader large cap indices such as MSCI World. In the US where there are deep markets in both small and mid-cap stocks, this is referred to as “SMID cap investing”.

Three compelling reasons to invest in smaller companies

1. Higher growth: Smaller companies have the potential to grow faster by expanding their markets. Large global companies in maturing markets are unable to match this. Think Amazon which started out as a small cap stock in 1998 trading at 8 cents, now considered a "mega" cap stock trading at around USD 100. Not all small caps are Amazons of the future but this growth advantage is well documented by historical evidence of small cap equity returns outpacing large cap equity over the long term. Analysis by Fama and French (1993) is perhaps best known for identifying the small cap premium, evidencing that small caps have a higher systematic risk which earns them a higher return premium.

The chart below illustrates this by comparing total returns for the MSCI Small Cap Equity Index against the MSCI World Index.

MSCI Small Cap Vs. MSCI World total returns

January 1995 - January 2023

source: MSCI data

Over the 20 years to 31 January 2023 the MSCI Small Cap Index has outperformed the MSCI World Index by nearly 2.3% pa, despite including the last three major financial crises of the Global Financial Crisis, the Global Covid Pandemic and Russia’s invasion of Ukraine.

2. Diversification: Most smaller companies are bringing new products and solutions to existing markets. Oftentimes they are innovators or disruptors. Companies like Xaar plc, a technology company providing precision digital printing across a wide range of manufacturing applications and Metro Bank, which is disrupting the traditional retail banking model. These companies offer access to growing markets that fall outside the broader investible equity indices providing diversification to traditional equity portfolios.

3. Market inefficiency: Smaller companies are under-researched by the financial analysts who focus most of their effort on the large and mega caps where institutional demand is greatest. This creates an "information gap" in small caps which experienced small cap investors can exploit to their advantage. Small cap equities are therefore one of the few asset classes with good evidence of active managers being able to add value more often than not1.

Small cap investing is not without its risks

1. More volatile share prices: Performance is likely to deviate significantly from any broad benchmark. Even daily, single small cap names may fluctuate significantly as it takes less trading volume to move prices.

2. Less liquidity: Small caps tend to offer less liquidity and so it may be difficult to exit an unfavourable position – this could significantly erode alpha if mismanaged. Thinner trading volumes also mean typical transaction costs are higher.

3. Information transparency (financial metrics, industry knowledge, and ESG data) is less readily available for small cap names. This is a potential advantage as described by the market inefficiency benefit above but it also presents risk. It will require investment of time and resource to research a single small cap company, which is why we generally prefer the use of an active manager with the time and resource to do so.

For investors with investment horizons of 10 years or more we believe the advantages of small cap investing outweigh the risks and will provide a compelling addition to a diversified portfolio.

Another perspective?

Evidence for the small cap premium has been challenged in more recent years – Cliff Asness and the team at AQR controversially declared in 2020 that “there is no size effect”. In essence they boiled down the extra returns for smaller companies as related to other factors such as higher market beta (think ‘risk’) and illiquidity. Although this dampens my enthusiasm for smaller companies, it doesn’t detract from the key point which is that smaller companies deliver higher returns in the long term (albeit with higher risk) and diversification from other factors. For patient investors able to bear higher risk, the rewards are there for the taking.

Another interesting finding from Cliff Asness (2018) was that smaller companies tend to be lower quality2 relative to their large cap peers. If investment returns on smaller companies are adjusted for this quality difference, size does matter – evidence shows the small cap premium is resurrected if "quality" is allowed for in the analysis. A finding which chimes with some active small cap managers who focus on investing in "quality" small caps.

Options for accessing small cap?

Most investors will choose to delegate to a fund manager through a pooled fund or for the larger institutional investors via a segregated account. There is a wide range of products from index-tracking funds to specialist, actively managed, regional funds. The US market has the widest range of products – broadly seven times more than the rest of the world put together – and these are dominated by actively managed funds.

The institutional pooled funds are generally daily traded and won’t hold any unlisted stocks. However trading volumes for smaller companies are significantly lower than for large and mega-caps so if there was to be ‘a run’ on the fund by investors, liquidity could tighten up and delay full redemption for a few weeks.

Managers with expert local small cap analysts are best placed to exploit the ‘information gap’ and so we prefer regional, active specialist managers. Unsurprisingly, this comes with a fee premium. Typical annual management costs for an actively managed small cap fund being at a 20bps premium to a large-cap fund.

The decision between a global versus regional approach to small cap investing is more nuanced. Larger investors with more resource and governance budget can choose a regional approach – selecting the best-in-class managers within each of the main regions. Whereas other investors may prefer to keep governance lower and appoint a single global manager. Arguably, a global manager can add value by increasing their allocation to regions which are expected to perform more strongly and reducing the allocation to weaker regions. However, in our experience, managers are rarely able to consistently time these macro-economic anomalies to their benefit.

In practice the US region represents around 65% of the S&P Developed World Small Cap Index so a possible compromise is to appoint a single US specialist to gain access to this asset class in a low governance way.

When to invest?

Timing of investment into small caps is more important than with many asset classes given the volatility. Small cap equity stocks tend to fall fastest and furthest in a market downturn. The 2020 pandemic was a case in point with the MSCI Small Cap Index falling by c.30% in the first 3 months of 2020 versus c.20% for the large caps in the MSCI World. However, small caps tend to recover fastest and furthest on the back of a recession, leading the charge in a bull market.

This is evidenced well by the chart below showing how over the last six recessions in the period 1980 to 2022, US small caps have on average underperformed large caps in the 24 months leading up to the start of a recession and outperformed in the 48 months on the way out.

Small- Vs. Large-Cap Average Relative Performance, Last Six Recessions (1980 to 2022)

Sources: William Blair and Bloomberg. Small-cap is represented by the Russell 2000 Index. Large cap is represented by the S&P 500 Index

In light of the market drawdown in 2022 and softening interest rates, small cap valuations look relatively favourable from here. The chart below illustrates the current cyclically-adjusted price to earnings ratio (‘CAPE’) for the MSCI Small Cap Index versus its history and compares this with the MSCI World. On this basis small caps look relatively cheap and so 2023 may offer a good entry point for this under-appreciated asset class.

Small Cap Vs. Developed and Emerging markets

Price-to-earnings ratio to 31.03.2023

source: Morningstar

Footnote:

1 For example, see the MSCI research “Evaluating Opportunities in Active Management” published in 2019 (https://www.msci.com/documents/10199/e3c14efc-8874-908b-f6d4-5581060a922a)

2 Quality typically defined as companies demonstrating factors such as higher returns on equity, higher gross margins, higher proportion of cash earnings, lower leverage or lower risk of insolvency