Debate rages on the big returns from small-caps; Smaller companies reliably outperform over the longer term

January 17, 2014 3:11 pm

Debate rages on the big returns from small-caps

By John Authers

Smaller companies reliably outperform over the longer term

Size matters. It is one of the least contentious issues in investment. When buyingstocks, the smaller the company, the better your chance of a good long-run return.There are disagreements over why this is. Eugene Fama, one of last year’s Nobel economics laureates, produced an exhaustive empirical study with Ken French, whose findings are almost universally accepted. This showed that over time, stocks that were small when bought unmistakably tended to outperform larger-capitalisation companies.

His explanation was that the so-called “size effect” could be explained by risk. Smaller companies are riskier, and their prices are more volatile. So investors get a discount when they buy, to compensate for that risk. That discount allows them to outperform in the long run.

Others think small-cap outperformance is not so rational, but more a matter of a market inefficiency. But nobody disagrees that small-caps outperform.

That still leads to two questions. Just why are small-caps outperforming so impressively at present? And why do not more investors take advantage?

The post-Lehman rally, now almost five years old, has been led by smaller companies. Since the market bottomed in March 2009, the Russell Top 50 index of the largest US companies has gained 111 per cent. Meanwhile the Russell 1000, covering the 1,000 largest stocks, has gained 150 per cent; the Russell 2000, covering the next 2,000 stocks, is up 197 per cent; and the Russell Microcap is up 220 per cent. Truly, the smaller has been the better.

This is not just a case of smaller companies falling more during the post-Lehman crash and gaining a lower baseline. Start the comparison before the crash in 2004, and smaller companies remain ahead (although microcaps slightly underperformed the Russell 2000).

In the UK long-running research by two London Business School academics, Elroy Dimson and Paul Marsh, sponsored by Numis, shows both that long-run smaller company outperformance has been great, and that 2013 was a particularly good year.

Their NSCI index covers the smallest companies that together make up 10 per cent of the UK’s total market value each year. When investment companies are excluded, this index returned 36.9 per cent last year, compared with 20.8 per cent for the FTSE All-Share index.

Since 1955 the NSCI has achieved an annual return of 15.8 per cent, compared with 12.0 on the All-Share. When compounded for more than half a century, this makes for spectacular returns. Over that period the NSCI has returned 11,605 per cent, against the All-Share’s 811 per cent.

More intriguingly the research also compares the relative performance of small-cap indices in 30 other countries, with data from MSCI going back to 2000. On average small-caps have beaten rival large-cap indices by 6.7 percentage points a year – an astonishingly wide gap.

There are only three countries where large-caps are ahead for the 21st century, and all appear to be special cases: Norway, where large-caps are dominated by the success ofStatoil; and Mexico and Malaysia, which suffer from large oligopolies that tend to crowd out smaller companies. Last year was a great year for global small-cap returns, at 32.9 per cent, but the premium over larger stocks was a typical 5.8 percentage points.

How has such a wide anomaly persisted so long? With smaller companies so plainly outperforming in the long run, it would seem obvious investors have overestimated their risks, and should pay more for them. However, the ride has been volatile. Since 1955 the NSCI has underperformed the All-Share in 13 years, including the recent crisis years of 2007 and 2008. This is not a good place for short-termists.

And the pattern of small-cap performance last year says something about investor psychology, five years on from the crash. Robert Schwob, of Style Research in London, points out that rapid market gains, such as were seen in 2013, would usually favour large-caps, because these are the stocks that those chasing the rally can most easily enter in a hurry.

He suggests that small-caps’ strong 2013 is one of a number of signs that investors’ confidence is returning. This could also be seen in the way investors put less weight on dividends and more weight on profit forecasts (implying a greater degree of trust that the economy is growing and that rosy outlooks are justified). Adding weight to this suggestion, smaller companies enjoyed least relative success in continental Europe, where confidence for the economy is weakest and where fears of a serious crisis remain strongest.

For the short term it is hard to see smaller stocks outperforming at the rate of 2013, unless economic growth exceeds the most optimistic forecasts. For the long term the smaller company effect is an anomaly that has endured for decades and made many people rich. Any portfolio should have a decent allocation to them.