The favourable outperformance of small-cap stocks over large-caps is a well-established phenomenon. However, whereas in the past professional investors routinely allocated 10 per cent or even 15 per cent to smaller companies, there was a marked decline during the credit boom, when investors sought higher returns elsewhere. 
Economic trends have, of course changed – so we can expect market trends to change too. With global growth likely to be much lower in the coming decade, we believe there will be a structural shift back into smaller companies as investors pay up for higher growth rates.
Globally, the small-cap opportunity set is enormous, but at the same time very thinly covered by analysts. This provides a fertile ground for active stock pickers, with plenty of scope for outperformance.
It has long been a truism in the investment world that smaller companies outperform their larger counterparts. Yet the numbers, when one looks at them, cannot fail to startle.
The Numis Smaller Companies index focuses on the bottom 10 per cent of the stock market by value. Its Annual Review in 2015 compared asset classes since 1955, one of the longest such studies ever produced. The results were pretty conclusive: small caps outperformed large caps by, on average, 3.4 per cent every year. The same story can be seen in nearly every major country across the globe, except those where large state enterprises skew the numbers.
Performance of indices over 20yrs
Source: FE Analytics
It is interesting that similarly positive returns can be seen even in low-growth environments. During the 1960s and 70s for example – a period marked in the UK by industrial strife, oil shock, inflation and currency problems – small-caps outperformed.
In short, it appears as though smaller companies are more able to buck the wider economic trend.
There are numerous reasons why small-caps should outperform their larger peers:
Sheer size: Just in terms of basic numbers, small-caps have the ability to grow in ways that are not possible for large companies. A £10bn company simply does not have the same potential double in size as a company with a £100m market capitalisation.
Agility: Smaller companies are also more agile. In difficult economic times, the options open to large companies with dominant market shares (and usually huge infrastructure already in place) do not extend beyond squeezing margins through price cuts, or cost-cutting. Small companies, by contrast, can adapt much more quickly to new market environments, or to capitalise on new ideas.
Shunned by most institutional investors: It is not uncommon for large institutional funds to invest hundreds of millions of pounds in just one company – whilst small companies do not have the market capitalisation to support this size of investment. In order to buy a position large enough to make a difference to their fund’s performance, most institutional fund managers would end up buying a substantial stake in the company. Positions of this size inevitably result in major regulatory and liquidity issues for fund managers.
Alignment of management and shareholders: Smaller companies are often run by their founders or a small group of managers who are more motivated to increase shareholder value. Very often, a small cap company’s board of directors has a far higher ownership of that company, so the board is far more incentivised to ensure their company performs.
Acquisition targets: In countries like the UK and US, with their vibrant markets in venture capital and private equity, there is generally a supportive M&A environment for smaller companies. Smaller companies’ status as acquisition targets is one factor in their long-term outperformance versus large caps.
There are, of course, drawbacks to investing in smaller companies.
The first and most obvious is that individually they are far riskier than large-caps. Scaling a business model is notoriously difficult. Many small companies do not have long operating histories or proven business models, which can make them more vulnerable to aggressive competition from larger rivals. With more limited access to capital, smaller companies can find it difficult to obtain financing to pursue new growth opportunities, or to endure economic downturns.
Small-caps are also more susceptible to volatility, simply owing to their size. Much less volume can move their share prices, and it is normal for their share prices to fluctuate in excess of 5 per cent in a single trading day. Lower trading liquidity means there may not be enough sellers at an acceptable price, or not being able to sell shares quickly. Low liquidity frequently results in higher transaction costs, too.
Yet the case for including a well-researched set of smaller, high-growth companies is compelling. In a period of low growth, low interest rates and low inflation, we believe investors will be willing to pay a premium for superior rates of growth.
Participation in small caps, as it stands today, still looks relatively immature. Their valuations are reasonably attractive compared to large caps. The chart below shows the valuation in February of US small caps relative to the S&P 500 – just three months ago they were the cheapest they have been relative to large caps since the Tech bubble.
For those investors prepared to take the attendant risk, small cap stocks can play a useful role in portfolio construction. Not only do their higher growth rates increase returns, but their lower correlation to the FTSE 100, for example, means that they can reduce portfolio volatility.
In short, the inclusion of small-cap stocks can make for a more efficient portfolio.
Although there are some ostensibly small-cap passive funds available, they tend to have holdings which are more towards the mid-cap range of market capitalisation. We believe the real opportunity lies in active funds, given the inefficiencies of the small-cap market.
The 80-20 rule of investing certainly applies when looking at small cap stocks: we would estimate that more than 80 per cent of City research focuses on under 20 per cent of publicly-traded companies.
With few analysts or fund managers performing in-depth research on small caps, an astounding number of companies get overlooked. Sparse analyst coverage means that the market is quite inefficient. With share prices frequently not reflecting underlying business fundamentals, there is huge scope for adept small-cap managers to outperform.
In addition, the shares’ lack of liquidity can also be used to the manager’s advantage. Most small companies have very few shares freely trading, which prevents many large institutions from investing. This reduces the number of buyers and can, in turn, cause the stock price to be unjustifiably low. Conversely, when a large buyer tries to buy an illiquid stock, the price can go up dramatically. Managers can take advantage of these distortions, aim to slowly accumulate the undervalued shares and hold on to them for the long term.
Conclusion
The favourable outperformance and diversification benefits of smaller companies are both well established. The less efficient small-cap market is, in our view, a principal reason for this. With a huge opportunity set, and scant analyst coverage, there are enormous opportunities for active stock pickers.
With valuations looking reasonable, and our expectation that global growth rates will be subdued for the next few years, we believe now is a good time to join the early stages of a structural shift back into smaller companies.
Andrew Morgan is an Alpha r:² portfolio manager at Walker Crips. The views expressed above are his own and should not be taken as investment advice.
