Have small companies lost their edge?

Countless studies have shown that over the many decades following World War II, there have been two essential building blocks to building wealth over the long term. The first is that shares, otherwise known as equities, have greatly outperformed bonds (albeit that has become a little less clear cut in recent decades). The second lesson is that within those equity markets, it has been a case of “the smaller the better”.

In simple terms, although companies with a smaller market capitalisation (market cap – the number of shares outstanding multiplied by the share price) are much riskier, the long-term returns from holding these stocks greatly outweigh those risks, producing returns far superior to holding government bonds, or even leviathan-scale businesses with a very large market cap.

Small is beautiful

We can see this clearly in one of the longest equity index series on record, namely the Numis Smaller Companies index (NSCI). This is backed up by a regular annual review, written by Paul Marsh and Scott Evans of the London Business School. The index was created 32 years ago by Professors Marsh and Elroy Dimson, and is the definitive benchmark for monitoring the performance of smaller and mid-sized companies in the UK.

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According to these academics, a £1 investment in the NSCI made when it launched in 1955, would have been worth £6,417 by the end of 2018, with dividends reinvested. The same investment in the minnows index, the Numis 1000 (made up of even smaller companies), would have grown to £15,213, while a corresponding investment in the FTSE All-Share would have yielded just £991.

This research is backed up by countless other studies in the US and beyond. There has, in effect, been a “small cap premium” – take more risk, and you get greater rewards. The consensus view among many small cap fund managers is that smaller companies can be nimbler, more focused on domestic markets and thus capable of sustaining higher long-term earnings growth.

The rise of the behemoths

However, this small cap premium varies hugely over time, and in recent months and years, the tectonic plates beneath the modern investing landscape appear to have started moving in new directions. If we take a look at the market moves in recent months in the US, for instance, a very different picture emerges. The five largest stocks in the benchmark US equity index, the S&P 500, now account for about a fifth of its total market capitalisation. That’s higher even than the 18% concentration level reached during the dotcom bubble in 2000.

Many strategists now maintain that we are witnessing a “scale-always-wins, winner-takes-all” process at work. In simple terms, various structural factors have given global mega caps a distinct advantage which has flowed through into stronger share price strength (in relative terms) compared to small cap equities. And the trend has been turbo-charged during the recent market rally, with very large cap stocks dominating returns.

Will small caps come back?

Analysts at US firm State Street have been digging around inside a broad stock market index called the MSCI World index. They discovered that during the panic and subsequent sell-off, the breakdown of the losses in equities varied between the constituents. The mega cap stocks (defined as the top five stocks across key markets, which makes up to 20% of the index) showed little impact from Covid-19. The top five emerging market companies contributed less than 5% of the index’s loss, despite having a 23% weight within the index. The number becomes more extreme for European companies – at just 1% – and “even more staggering for the US, in which the top five actually recorded a gain, but the rest of the index was responsible for 100% of the entire loss. Whilst most have suffered due to the virus, the virus has also solidified the mega caps!”

Small caps, and especially those within perceived growth sectors such as technology and healthcare, have subsequently aggressively rebounded in the months following the March panic. But the mega large cap leviathans continue to dominate. So are we genuinely seeing this permanent “winner-takes-all” shift, as some have hinted? Or is this a passing fad with small caps eventually re-asserting their edge? The one thing that financial history teaches us is that most markets and trends eventually revert to the mean (the average) over the long term – in which case small caps’ day will surely come.

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