The real reason small-cap stocks win out

Jim Slater, one of Britain's best-known investors, summed up the reasons behind his preference for small caps in one line: "Elephants don't gallop." His point was that, if you're looking for rapid share-price gains in the short term, it's a lot easier for a small company to double in size, than for a large rival.

But it's not just the short term. Several studies on both sides of the Atlantic have demonstrated that, over the long run, small caps deliver better returns (on average) than large caps.

The usual reason given for this small-cap premium' is that shares in small, fast-growing companies are riskier they go bust more quickly and more often, so you expect a higher return. But as Robert P Seawright, chief investment officer at Madison Avenue Securities, notes on Rpseawright.wordpress.com, a physicist called Geoffrey West has an alternative explanation for just why small is beautiful.

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Applying biology to finance

West is a renowned physicist who, as Seawright notes, has "always wanted to find rules that govern everything". His quest has taken him beyond physics and into biology, where he claims there is one "overarching lesson": that "as organisms grow in size they become more efficient".

Large animals use energy more effectively by employing what economists call economies of scale. This is why big animals live longer than little ones: "life span, lifetime number of heartbeats, metabolic rate and many other measures scale with body mass".

Applying this argument to companies, this might seem to suggest you should invest in larger ones they're more, efficient after all.

But here's the rub while "all mammals grow and develop quickly early on", that growth will "flatten out over time". In other words, most of the growth is done in the early stages of an organism's life span.

The reason this matters for investors is that companies show a remarkably similar pattern of growth over their typical life span of 40-50 years. West looked at the growth curves for thousands of publicly traded US companies. He used a wide range of variables, including valuation, assets, revenue, profits and employees.

While he found that sales do increase linearly with size (ie, roughly one-for-one), profits don't indeed, they decrease relative to sales.

So while a firm may grow in size from 100 to 1,000,000 employees, its profits won't grow at the same rate they will only grow at a ratio of roughly 0.8:1. In other words, like animals, companies are destined to grow fast for a while before slowing down, then declining and dying.

Bureaucracy kills innovation

So why does this happen in companies? West's key observation, says Seawright, is that "as companies grow, they become dominated primarily by infrastructure rather than people, and by economies of scale rather than innovation".

In short, as firms sacrifice "creativity and innovation" to "bureaucracy and administration", they are overtaken by younger firms and eventually vanish altogether. Says West: "companies are killed by their need to keep on getting bigger".

This suggests that the premium attached to small firms isn't just about risk. It turns out that size is, in itself, a drag on productivity and profits. So favouring small caps makes sense. My colleague Tom Bulford writes on these regularly in his free email, The Penny Sleuth.

This article is taken from Tom Bulford's free twice-weekly small-cap investment email The Penny Sleuth. Sign up to The Penny Sleuth here.

Information in Penny Sleuth is for general information only and is not intended to be relied upon by individual readers in making (or not making) specific investment decisions. Penny Sleuth is an unregulated product published by Fleet Street Publications Ltd.