Small & Mid-Cap Equities: Digging for victory
It all started in 1981. Back then, an academic paper was published which is widely acknowledged as the first systematic attempt to show that smaller companies tend to outperform larger ones. The Swiss author, Rolf Banz, went on to work in senior roles for many asset managers, including Pictet.
At a glance
- There is strong evidence to suggest that smaller companies outperform larger ones over the longer term.
- There are several reasons to explain why this effect exists.
- The definition of a small-cap is much more complex than it seems.
- Unearthing the specifics of the business is particularly important for small-cap investors.
Of course, Banz did not invent small or mid-cap investment. Many had invested in smaller companies before then. But it did give a new level of rigour to the debate about the relative merits of investing in such firms. This has become known as the small, or smaller, company effect – also known as the small company premium.
Not surprisingly most small and mid-cap fund managers uphold some version of this claim. No doubt many of them moved into the arena in the first place because they believed in its potential for outperformance.
The raw performance figures certainly seem to bear out the story in most cases. It is true that small-caps tend to outperform large-caps over the long term.
However, as with many such claims, it is necessary to question them more deeply. There are several areas in which this can be done.
For a start there is time. Even the most ardent advocates of the small company effect tend to agree that it operates over the long term. There are times, particularly during economic downturns, when small-caps tend to underperform their larger peers.
Paul Marsh and Andrew Dimson, the two doyens of the small company effect in the UK, have expressed doubts about when the effect seemed to vanish. In 1986 they published a paper arguing that there was evidence of a small company effect in the UK. But then in 1998 they published a paper bemoaning the fact that the effect seemed to have disappeared or even gone into reverse just after their earlier paper. But soon after the latter paper was published, and just as the effect was declared dead by some critics, it seems to have reasserted itself in the British market.
Stephen Miles, the head of research for EMEA at Towers Watson, says: “The key thing is that the cycles are extremely long-term. They can be a decade long in terms of duration.”
Another dimension to consider is risk. As with any investment asset, it makes little sense to consider return in isolation. It takes no great skill to achieve high returns with enormous risks.
In the case of smaller companies, it is generally accepted that they tend to be riskier than large ones. They are typically more volatile but, arguably, there is also a greater chance of financial distress of even failure. From that perspective the small company premium is not as large as it might appear from the raw performance figures. Nevertheless, the advocates of investment in smaller companies argue that there is still a premium to such investment, even on a risk-adjusted basis.
More complex is the question of whether what seems like a size effect is, in fact, a proxy for something else. For example, it could be to do with the generally lower liquidity of small-caps. Investors are, in effect, demanding higher returns for investing in small-caps to compensate them for forsaking a degree of liquidity. Filip Weintraub, the lead portfolio manager for the Skagen Focus fund, says fear of illiquidity “makes a lot of institutional investors stay away from them”.
On the other hand, the effect could be partly or even entirely down to the concentration of small-caps into particular sectors. Diane Bruno, the manager of the Mandarine Unique fund, says: “If you are small-cap investor you invest in quite different types of companies than if you are an investor in large-caps.” For instance, banks are generally large-caps and technology companies, at least in the US, are usually small-caps. Therefore, if the technology sector is doing better than the banking sector, then, all things being equal, small-caps will outperform large-caps. “The size effect can be quite sectorially driven,” says Towers Watson’s Miles.
While some look for rational factors to explain the small-cap effect, others look to investor behaviour. Since investment institutions place relatively little emphasis on small-caps they tend to be neglected. As a result, prices do not tend to be bid up, as can happen among large-caps.
Harry Nimmo, the head of smaller company equities at Standard Life Investments, highlights two types of behavioural biases in this area in a briefing (Smaller Companies: The long-term opportunity, June 2015). First, investment consultants tend not to break down smaller companies as a distinct asset class. Therefore, an important class of advisers systematically overlooks the potential of smaller companies.
Nimmo also points to the indirect effect of the rise of passive investment on the sector. Smaller companies, with their lower liquidity, do not lend themselves to index investing. Passive equity funds are better suited to large-caps than small-caps.
The advent of synthetic exchange traded funds (ETFs) has exacerbated this trend. Such vehicles use derivatives to replicate asset price movements rather than investing directly in the assets themselves. But options and other derivatives tend to be much more available in large-cap markets than in small-caps. This therefore adds another market bias away from small-caps.
Although the word ‘bias’ has negative connotations in normal English usage, here it suggests a key advantage for small-cap investors. If small-caps tend to outperform over time, whatever the reasons, it provides an edge for those wanting to take advantage of the asset class.
The definition of a small-cap seems simple but the more you try to grab it the more slippery it becomes. By extension, the same is true of mid-caps.
Even the criterion used to define small or big is itself open to question. Market capitalisation is the preferred metric in investment circles but size could equally be measured by revenue, earnings, profits or another criterion. A company that is big by one measure is not necessarily large by another.
But even if the investment standard of market capitalisation is taken as a given, it still leaves open many questions. What constitutes a large-cap in one market can be a small-cap in another. The methods for comparing relative capitalisation with particular indices or national markets vary.
Morningstar’s fund categorisations provide a useful means for comparison as the financial information company covers the main investment regions. For example, as of 20 November 2015 the largest small-cap in the US market could have a capitalisation of as much as £818m (€1.4bn). Yet, in Europe such a company would be counted as a mid-cap and in every other part of the world it would be a large-cap.
These figures vary over time. As the markets grow, the threshold for what constitutes a large-cap and what constitutes a small-cap rises over time.
Adding other categories such as mid-caps and giant or mega caps only adds to the complexity. It raises further questions about where to draw the lines between different categories of companies. But even the simple division between small and large-caps raises enough tricky questions.
Sometimes the selection of indices themselves skews the definition. For instance, the smaller firms in the FTSE 100 large cap index would be classified as mid-caps or even small-caps in some markets. That is because membership of the index is dependent on being one of a set number of the largest companies.
This helps explain why the term small-cap in the UK can have a different meaning to that in many other countries. “There is a big difference between what the UK thinks is small-cap and what the rest of the world thinks of as small-cap,” says Andrew Neville, a global small-cap fund manager at Allianz Global Investors. What are called small-caps in the UK would often be defined as micro-caps elsewhere.
The alternative approach to indexing is to define the membership of indices relative to a percentage of market capitalisation. For example, the MSCI Europe Small Cap index captures small-cap representation across 15 developed markets in Europe. It covers about 14% of the free floated market capitalisation or 897 constituents.
Leaving aside the exact definitional boundaries, there are several characteristics that make small-cap stocks distinct as an asset class. Some of these, such as lower liquidity, have already been discussed. But there are others that should be highlighted.
For a start, small-caps tend to be under-researched compared with their larger peers. “The further down the market scale you go, the less sell-side research there is,” says Cedric Durant des Aulnois, the chief executive of Montanaro, a small-cap investment boutique. His goal is to locate a ‘sweet spot’ where there is only a small amount of sell-side research.
Another important consideration is the tilt towards growth companies. That is, investing in firms that are considered to have good growth potential, rather those companies that are cheap relative to their estimated intrinsic value.
Mandarine Gestion’s Bruno points to Ingenico as an example of a promising growth company. The French manufacturer of payments terminals might be small when measured by its market cap but it is a dominant player in its field. Bruno estimates that it has a 40% share of the market for payment terminals worldwide. She also sees substantial potential for growth through its innovative capacity and drive into many international markets.
Weintraub of Skagen Focus also favours small firms that are dominant players in niche markets. “A small company can be a ‘big gorilla’ in its ecosystem or operating environment,” he says.
He gives as an example Omega Protein, one of the largest producers of Omega 3 fish oils in the world. In the US it has a 25% market share.
Through his understanding of the specifics of the company, he can take a view on why it is an attractive investment. In Omega Protein’s case, its manufacturing process involves boiling North Atlantic herring to extract the oil. There are good reasons why new entrants to the market might meet resistance if they tried to replicate the process.
“Believe me, no one wants this as a neighbour,” he says. “The smell carries for miles.” For that reason it has what he calls a “strategic defensiveness”.
Another advantage Omega Protein has is that fish oil – unlike raw fish – stores for years. That means its business is much less cyclical than its classification as a fisheries business suggests.
Such tales of the quirks of individual firms in a way capture the essence of small-cap investment. It involves getting to know the intricacies of how relatively simple businesses work. The information is publicly available but it is often not widely known. It is apparent only to those who have the inclination and determination to dig for it.