Why Small-cap Shares Beat Large

published 6 June 2014

140606-london-stock-exchang — Small-caps consistently outperform blue chips

In 1833 a young man called Marcus Samuel started a business in Houndsditch, selling exotic sea shells imported from the Orient. They were used to adorn the decorative bowls and boxes popular in Victorian England. His sons took over the business, and in 1878 began handling consignments of cased kerosene, and built 12 oil tankers. Over 130 years later Royal Dutch Shell is still going strong. Today it is valued at over £140bn, but it is struggling to grow. It has become so big, its tentacles have reached to all corners of the globe, and now it is having difficulty replacing its oil reserves.

In 1987 a virtually unknown Finnish company called Nokia launched the Mobira Cityman. This was the first handheld mobile phone for mobile networks. It was the size of a brick and cost about £3,000. But it launched the communications revolution. Suddenly everyone wanted a mobile phone. Nokia managed to stay ahead of the competition for a few years and made a fortune for its shareholders. In 1999 it single-handedly increased the size of the Finnish economy by 1.5%, and by 2006 its revenue exceeded the country's state budget. Today the mobile phone market is fiercely competitive. Nokia has lost its dominance and its glory days are in the past.

In 1996 two students of Stanford University, Sergey Brin and Larry Page, had a notion that a search engine that analysed the relationships between websites would produce better results than existing search techniques. Google was born, and today what started as a bright idea has become a business worth over $150bn. Brin and Page are two of the richest men in the world, and anyone who bought the shares ten years ago has made a fortune too.

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I could give you numerous more examples of companies that have given outstanding rewards to their shareholders, but these three are sufficient to illustrate a few points. First of all, every business starts out as somebody's bright idea. What happens after that depends upon how good the idea is; whether anyone else has thought of it; whether it can be turned into a real business; and whether the people who run the company are smart or foolish. But the simple point is this: if you want to make big money, you have to get in early. You will not make big money if you buy into Shell or Nokia now. You might do OK. Both companies are well established in industries that are not going to disappear tomorrow. But for both of them, real growth is a struggle.

You can look at this as simply a question of mathematics. There is a sort of law of big numbers. Shell is valued at over £140bn, Google at over $150bn. To double from here is tough. Apple briefly became the biggest company in the world by value in 2012, worth $640bn. It seemed unstoppable. It's still the same great company less than a year on; but the market now thinks its future looks a bit trickier, and today values it at under $530bn. In a competitive world there's a limit to how many iPhones you can sell at premium prices.

'Elephants don't gallop'

But if you have a company that is valued at just a few million then it can double or treble or grow ten-fold in size without having to add business worth billions. As the great investor Jim Slater famously said, "Elephants don't gallop". Now, there is a downside to this. Elephants may not be able to gallop, but they take a bit of knocking over. Shell, Apple and Google may struggle to grow in the next decade but I would bet that they will still be around at the end of it. Even sickly elephants like Nokia are still around in some form. Small companies are often young companies. Perhaps they have yet to convince customers of the benefits of their products. Perhaps they are still spending plenty of money but not making any sales. Perhaps they find themselves fighting for business against bigger competitors. So if you invest in a company before it has proved an ability to make profits, you are taking a risk.

Despite, or perhaps because of this element of risk, returns from investing in successful small companies are better than returns from investing in large companies. This is not just my opinion. Stock market returns have been analysed ad nauseam, and there have been a number of studies that look at the 'size effect' in other words does it make any difference whether you invest in large companies or small companies?

So far as the UK stock market, let us return to professor Elroy Dimson and his colleague professor Paul Marsh of the London Business School. They have calculated that over the last 55 years an investment of £1,000 in the average small company would have grown to be worth £2.6m. That is a return of about 17% per year. But £1,000 invested in the average large company would have become worth just £0.5m. That is a return of just 7.4% per year.

This is a huge difference, and there is absolutely nothing to prevent you from capturing this excess return.

And if you can capture this little bit of extra return each year, you will end up with a great deal more money.

The phenomenon of superior returns by small companies is not peculiar to the UK. In the USA, Dartmouth University finance professor Kenneth French and University of Chicago finance professor Eugene Fama have found that in the period 1926-2005 the average return from small stocks was 17.1%, versus 10.2% for large stocks.

And a second study of the US stock market by Ibbotson, covering the period 1972-2006, found that while the S&P Index of 500 large companies made, on average, 11.1% per year, the return from small companies was 14.8%. That means that $10,000 invested at the start of the period would have grown to $413,000 had it tracked the S&P 500 Index, but to $1,261,000 had it tracked the Ibbotson's small company index.

So the evidence is conclusive. There will be odd individual years when small stocks don't do as well; but over the long term they prevail. The only real debate is why this small company advantage persists. After all, the stock market is supposed to be efficient, and if one area of the stock market is consistently doing better than the rest, you would expect that investors would jump upon it, capture that advantage and eliminate it for others. It persists for a number of reasons.

Three reasons penny shares can outperform

The first of these is that so far as the stock market is concerned, familiarity does not breed contempt. Investors, whether amateur or professional, feel comfortable investing in companies that have been around for a few years and have a certain size and stature. Look at any mainstream investment fund and you can be sure that the top ten holdings will be the same overly familiar big stocks like Vodafone, BP, HSBC, Glaxo etc. There is a 'herd instinct'. City fund managers live in permanent fear of losing their highly paid jobs. There is a lot of pressure not to mess things up. This can make them cautious and reluctant to take a chance. Think of a herd of zebras roaming the veldt. Those on the outside get the pick of the fresh grass; those in the middle have to make do. But those on the outside of the pack will be the ones to be grabbed by the claws of a passing lion. It is all about risk and reward. If you want the best rewards you must be prepared to take a risk. The majority of investors, for one reason and another, do not want to take a risk. They prefer to invest in the same large and familiar companies held by most other investors. This is their comfort zone.

But City fund managers have a second reason for investing in big companies. They have to. They are responsible for investing billions of pounds, and they have to do something with it. This is not too difficult, so long as they stick to big shares. They can buy £50m of shares in Shell, or Barclays Bank, or Vodafone without any trouble at all. But £50m would buy many small companies lock, stock and barrel. Take a company with a value of say, £20m. Assume that half of the shares are owned by the founding directors. That leaves £10m. Now assume that £9m of these shares are held by long term investors who like the business and have no intention of selling. That leaves just £1m of shares that can be bought and sold on the stock market. That is fine for you and me. We can invest our few hundred pounds into such shares without any trouble. But this is no good for City fund managers. They have to find shares into which they can invest millions of pounds. So they stick to large companies, and ignore the small fry.

This has an important consequence. Stockbrokers make a living by persuading people to buy and sell shares. In order to make the case for a particular company they employ analysts whose job is to write research reports. Included within these reports are forecasts of future profits and an assessment of the correct value of the shares. These assessments are by no means accurate, but still they are enough to persuade fund managers to buy the shares, giving the stockbroker some commission income.

Research reports enable stockbrokers to drum up business. But their purpose is defeated if those who are persuaded by their argument simply cannot buy or sell the shares in sufficient quantity. If the subject of the research note is a large company this is not an issue. But if the company is very small, then it can be. It's just not commercial to employ many analysts to cover small companies.

That then, is the third reason: the bottom line is small companies are 'under-researched'. This is where the private investor has an opportunity. I am not interested in investing in stock market giants. They are too large to offer the possibility of fast growth; they are huge and complex and very difficult to truly understand; but above all they are chewed over each and every day by analysts and fund managers. So it is most unlikely that I could have any unique insight into them. With small companies though, the situation is quite the opposite. They are ignored in the City. In fact a common complaint from many small company executives is that they cannot get professional investors to take them seriously. This is why Red Hot Penny Shares fills such an important role.

But for anyone prepared to do a bit of work it is quite easy to investigate a small company. There is plenty of published information, and I have found that the executives of these businesses are very willing to meet me and explain what they are doing. So there is a real chance to come up with insights, and to identify those small companies that are doing well and have bright prospects. And the irony of this situation is that once they have got bigger, City investors will start to take an interest and provide the share with a new wave of support. The earlier you can get in to a successful company the more money you will make.

It's my job here as editor of Red Hot Penny Shares to do this research on behalf of private investors like you day in, day out. To read about the latest small company investment opportunities I'm most excited about - and to claim a special 90-day trial to get my research sent direct to your email then click here to get started.

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David Thornton is a small cap share expert with over 30 years’ experience in the investment world. He was an equity fund manager at Henderson Global Investors for 17 years, and in 2006 he launched the Matrix New Europe Fund, investing in equities throughout Eastern Europe, Russia and Turkey.

Recently, David took over as editor of the UK’s best-selling small cap newsletter, Red Hot Penny Shares – where he can fully indulge his passion for hunting exciting small share companies across the country. He also writes our free Penny Sleuth email.