What’s happened to the small-cap effect?

In 1993, Professors Eugene Fama and Kenneth French, subsequently awarded the Nobel prize in economics, published research on the “small-cap effect”.

They showed that since the 1920s, the 10% of US stocks with the smallest market capitalisations had out-performed the 10% with the largest by an annualised 2.4%.

This followed earlier research by Professors Elroy Dimson and Paul Marsh of the London Business School, initiated in 1989 but backdated to 1955, showing similar outperformance in the UK.

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In 2018, they estimated the annual outperformance of the All Share index by the bottom 10% of the market at 3.4%. The research has been replicated around the world in all markets and extended to cover subsequent periods, growth vs value, small vs microcap and other factors.

Our question today is: why does it work, and will it still work in the future?

There are good reasons for small-cap outperformance

Why do small-cap stocks outperform? The answer is quite straightforward.

Smaller companies are less liquid than larger ones, more volatile and more numerous. With fewer analysts covering each stock and so much to cover, they are much more labour intensive for investment managers. The excess return they offer, without which nobody would invest, is the compensation for this.

The performance data since the end of 2000 shows continued outperformance with the MSCI World Small Cap index returning 9.2% in dollars, compared with 6.4% for the MSCI World index. This out-performance, according to Dimson and Marsh, is reflected in nearly all markets.

Investors in small-cap investment trusts get an added bonus. Not only does a portfolio of smaller companies mitigate the individual risk of each investment but trusts in each region out-perform their regional benchmarks. Maybe their managers are smarter than the average equity manager, but the greater choice of investments is also an advantage.

Chris Berrier of Brown Advisory also sees an advantage in the volatility of small caps. “You can take advantage of the volatility to add value. It is painful in the short term but it allows you to pick or add to good positions.”

This investment trust outperformance varies from an annualised 1.4% for the US specialists in the last five years, to 3.8% in the UK, 4.1% in Europe, 7.4% in Japan and 8.5% globally, though these numbers are distorted by small sample sizes outside the UK and some exceptional performances.

As a result, it would be natural to assume that smaller companies trade at a valuation premium to larger companies and that small cap investment trusts trade at a premium to net asset value (NAV).

Incredibly, however, this is not the case.

You can still buy small-cap investment trusts for less than their portfolio value

UK and global small cap specialists trade at an average discount of 10%, Japanese trusts at 4%, and European and US trusts in between.

Meanwhile, the MSCI World index, according to MSCI, traded on a forward multiple of 18.3 times earnings at the end of January and 3.2 times book value compared with 16.7 and 1.95 for the MSCI Small Cap index. What has happened?

The last five years have not been kind to smaller companies with an annualised return of 10.1% compared with 13.25% for the MSCI World index. There are plausible explanations for this underperformance, notably the growth of index funds, according to recent academic research. Money has flowed into funds tracking the MSCI World index and, especially, the S&P 500, pushing up the valuation of large caps.

There are index funds focused on small and mid-cap stocks, but they are more expensive and have larger tracking errors. International investors, in particular, focus on large caps first, pushing up valuations. If they buy direct equities rather than index funds, they focus on the mega-caps which have become household names, such as Amazon, Apple and Tesla.

These companies have benefited from the continuing trend of globalisation, which means that an increasing number of companies see the whole world rather than their home country or region as their market.

This, though, is reminiscent of another period of small cap under-performance – the late 1990s. In that mega-cap mania, large companies merged with each other, cheered on by investors who pushed up their share prices. Cost savings proved illusory, competition diminished and corporate bureaucracies were created.

The ensuing companies, such as BP, Vodafone and Glaxo, became dinosaurs with, at best, stagnating performance. This has held the UK market back for 20 years.

Despite recent deals such as Microsoft’s $67bn acquisition of Activision Blizzard, today’s mega-caps prefer to buy back shares or develop new ventures internally. But the old saying that “trees don’t grow to the sky” still applies – growth is not infinite. Over the next five years, it is highly likely that small (and mid) caps will outperform.

The end-of-the-world crowd is still pumping out dire warnings about the stockmarket, which may put investors off subscribing to their Isas this year and next, but that would be a mistake. Investment trusts focusing on small or mid-caps or with at least a significant exposure to them, look well placed for the longer term even if the current market setback is not over yet.

As Ollie Beckett of Janus Henderson says “the appeal of smaller companies is that you can invest in the winners of tomorrow. This is where you tend to find growth in the market.”