Magazine Extracts – Small Caps, Big Opportunities

The added value of Small Caps in portfolios

Despite the risky reputation of small cap investing, and the current concerns about the lack of quality, small-caps can deliver high returns as an asset class and this is reflected in the interests of institutional investors and fund selectors. Individual small-cap stocks offer higher growth potential, and small-cap value index funds have been shown to outperform the S&P 500 in the long-run. Small-caps currently account for around 15% of the global equity universe. One of the advantages of small-cap stocks in times of crisis is that, although they are very sensitive to economic sentiment, they have the potential to recover faster than large-cap stocks as the economy turns around, allowing investors to capitalize on the potential gains.

Why Small Caps can be of great value in portfolios

Michel Iglesias del Sol, Head of Investment Strategy at Kempen Capital Management

Stocks of smaller companies, small caps, have recently been in the spotlight due to their disappointing performance during the COVID-19 sell-off. The MSCI World Small Cap Index underperformed the MSCI World Index by more than 7% in March, and by 9% over the first quarter of this year. Small caps have shown a strong recovery however in the second quarter, highlighting their sensitivity to economic sentiment.

The returns in the first six months of 2020 illustrate a well-known fact about small caps: they display more volatility than large cap stocks. The question then becomes whether an investor can expect to be rewarded for this higher risk? Looking at historical data, the answer to this question appears to be a convincing yes. Since the 1940s, US small caps (where we have the longest available data series) have, on average, returned 1-2% p.a. more than large-caps. This compounds to a substantial difference over time. Over the last twenty years, small caps have outperformed large caps by more than 2% p.a. in Europe, North America and the Pacific.

We can point to several reasons to explain this outperformance. For example, the focussed and more flexible business models of smaller companies, or low interest rates, which have boosted M&A activity (which small caps investors can profit from). 

The higher performance of small caps is often linked to the so-called size effect. This size effect (or size factor), together with the value effect first demonstrated by Fama and French, entails that stocks of smaller companies will outperform large cap equities in the long run. Other factors such as momentum, quality and low volatility were identified later.Contrary to these other factors though, it is important to notice that small cap equities actually represent a genuinely different universe, compared to the familiar large cap equity indices. Well-known indices such as the MSCI or FTSE World index typically only contain large cap and mid cap stocks. This means that an investment in small caps will add new stocks to a portfolio, increasing diversification. Put differently, factor strategies will generally only lead to different preferences and weights within a large cap portfolio. But small caps will add new stocks to the mix. You do not need to believe in the added value of factor investing, to appreciate the benefits from small caps.

Global Small Caps: why you should hire specialists 

Pieter Laan - Head of external manager selection at IBS Capital Allies

Investing in active Global Small-Cap funds is attractive. From an asset allocation point of view, historical data suggest there is a premium to be made by investing in Small-Caps. 

In the USA, US Small- Caps averaged an annualized premium of more than 1% since the 1940’s. Global Small-Cap equity investing is a newer asset class, and the results are promising. The MSCI Global Small Cap Index generated an annualized return of 8.0% since the millennium compared to 4.7% for the large-cap heavy MSCI World Index.

The most cited reason for the existence of the small-cap premium is lower liquidity of the shares, the so-called liquidity premium. Other research suggests that outperformance is also driven by the fact that smaller companies are:

So, we have an asset class that could earn a premium, but why should we exploit this via active management? The answer is two-fold. First, the percentage of active managers that outperform the index is high (see graph). Morningstar analysis shows that long-term, around 40-45% of the Global active Small-Cap managers outperform their index. In 2020 that number is above 50%, which shows that many managers are navigating their portfolios well through the COVID-19 storm. Second, the availability of passive solutions is limited. Most Small-Cap indices consist of several thousand stocks (the tail being very illiquid) which makes it a costly exercise to replicate. 

Apart from performance there are also several qualitative reasons why investors would do well to choose for active management in Global Small-Caps. Investment universe, research coverage and dispersion are the key words here.

At IBS Capital Allies, we conducted a Global Small-Cap search about 18 months ago for our fiduciary (advisory) clients. During the search we met 22 fund managers. What we noticed is that most of the fund managers are fundamental bottom-up stock pickers with a focus on quality and growth characteristics. The number of quant- and value managers in the universe is low. We have selected the following three funds for our clients: Silvercross Global Small-Cap Fund (managed by a team that works in another IBS subsidiary), Columbia Threadneedle Global Smaller Companies Fund and Baillie Gifford Worldwide Discovery Fund. 

Each of these funds has a very strong long-term track record. All three have a quality growth bias and at first sight may look similar. But when analyzing the underlying philosophy and portfolios, we notice clear differences between the strategies which regards to concentration, turnover and sector allocation. The overlap in holdings between the three funds is limited. 

For the full article please visit our Magazine's Online version.