Despite their consistently strong returns and outperformance, why is the smaller companies sector still systematically underappreciated?
Smaller company investing certainly entails additional considerations, such as liquidity and risk, over and above mainstream equity investing. The sheer number of companies involved also makes investing in global smaller companies a particular challenge, placing a premium on a workable and reliable investment process that above all has the potential to deliver consistently strong returns in the medium and longer term.
The first 10 years of the millennium were frequently described as a ‘lost decade’ for equities. Global stock markets generally have since strengthened considerably, though long-term returns from large- and small-cap equities have diverged starkly.
Between 1 January 2000 and 31 December 2014, global large-cap equities delivered an 81.1% total return compared with 332.2% from smaller companies (Source: Thomson Datastream).
Economies of scale
The economics of investment banking dictate that equity research analysts cover the largest companies, and hundreds of pages of research about these companies are published regularly.
Consequently, it makes economic sense for some analysts to restrict themselves to covering a small number of very large companies. Analysts at ‘bulge bracket’ investment banks have been known to work full-time on only two or three companies – Vodafone and Exxon, for example, are covered by 38 and 30 individual analysts, respectively. This suggests everything that could possibly be known about each of these companies is already known.
While smaller businesses may be less complex there is less research available, and what is on offer is often much shallower. This information gap opens up opportunities for compelling investment ideas others have yet to discover.
Investment managers often neglect illiquid or hard-to-buy shares that may have restricted free floats. This may be for sound reasons, such as concerns over fund outflows dictating forced sales, or because some investment managers have shorter investment horizons and so trade aggressively.
There are two key factors that suggest smaller companies will remain underappreciated in the longer term, meaning the sector should continue to reward those investors who seek it out.
First, institutional investors – often a barometer for future retail investor behaviour – follow the advice of investment consultants that help them design their long-term investment strategies, and they tend not to separate smaller companies from the wider ‘equities’ category.
Second, index trackers and exchange- traded funds now represent a meaningful proportion of the global stock market. According to Lipper, between 2003-13, passively managed assets have increased from 4% to 12% in Europe, and from 11% to 25% in the US. Due to the sheer number of stocks and much lower levels of dealing activity, smaller companies markets are difficult to track passively, hence there are few small-cap passive funds available.
Performance factor
These factors contribute to the ongoing neglect of the smaller companies sector, despite the strong returns it can offer. While lower-risk smaller companies have been shown to outperform higher-risk small caps, the asset class as a whole also outperforms on a risk-adjusted basis.
Our analysis of risk-adjusted returns between January 2001 and December 2014 showed smaller company returns outstripped their large-cap peers worldwide, except perhaps for the Asia-Pacific ex-Japan region. In other words, small caps tend to generate higher returns per unit of risk assumed.
‘Globalisation’ may be seen as a hackneyed term nowadays but it means global smaller company investing can now be conducted in a much more systematic and process-driven way, thanks to greater communication; closer assimilation of company and investor goals; accounting standards and corporate governance attitudes slowly converging; investment banks helping international corporate access; and research.
The smaller company paradox is likely to remain for a while, thereby continuing to offer investors deploying a robust and consistent stock selection process with attractive long-term returns.
Performance factor
These factors contribute to the ongoing neglect of the smaller companies sector, despite the strong returns it can offer. While lower-risk smaller companies have been shown to outperform higher-risk small caps, the asset class as a whole also outperforms on a risk-adjusted basis.
Our analysis of risk-adjusted returns between January 2001 and December 2014 showed smaller company returns outstripped their large-cap peers worldwide, except perhaps for the Asia-Pacific ex-Japan region. In other words, small caps tend to generate higher returns per unit of risk assumed.
‘Globalisation’ may be seen as a hackneyed term nowadays but it means global smaller company investing can now be conducted in a much more systematic and process-driven way, thanks to greater communication; closer assimilation of company and investor goals; accounting standards and corporate governance attitudes slowly converging; investment banks helping international corporate access; and research.
The smaller company paradox is likely to remain for a while, thereby continuing to offer investors deploying a robust and consistent stock selection process with attractive long-term returns.
