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10 US giants now represent a fifth of the MSCI World All-Country Index, the highest concentration in decades. In most parts of the world, large companies have left their smaller counterparts in the dust. Is the idea that small companies outperform – known as the small-cap premium – dead, or is it just resting?
The outsized returns of small firms relative to their larger counterparts were documented in the early 1980s using evidence from the half-century to 1975. This idea has found theoretical support. Higher returns compensate investors for taking on the greater risk of backing smaller, newer companies – although this can be minimized in a diversified portfolio. Most importantly, it compensates investors for higher spreads, higher trading expenses and supervision costs.
Over the long term, small-cap companies outperform larger companies, according to the UBS Global Investment Returns Yearbook. Over 43 years in 34 markets, the average monthly premium for large caps was 0.21 percent. But the premium set in the 1980s was much larger. It can disappear — sometimes for years at a time — after periods of strong performance. This leads to a decline in the long-run average.
Short-term economic factors shape sentiment toward small businesses. They are often hit hard in recessions because their revenue sources are less diversified. Small-cap valuations are more sensitive to interest rates as well.
By this logic, the prospect of lower interest rates should provide a boost. The boost would be particularly welcome in the UK, where low valuations are making companies target takeovers. However, the index evaluation is distorted by losers. The FTSE SmallCap index trades at a price/earnings ratio of negative 139 if investment companies are excluded.
Over the last quarter of the last century, “deaths” from takeovers and delistings have exceeded “births” in the Deutsche Nomis small-cap index. But the ranks of the index, which represents the bottom 10 per cent of the main UK market, were also swollen by “fallen angels” in the December rebalancing exercise. Companies that were previously too big for the index include Watches of Switzerland, Indivior, Ashmore Group and Dr Martens.
Fallen angels may revive. But in general, investors have not prospered by betting on poor performers for change. Momentum investing – continuing to buy winning stocks and sell losing stocks – has been an effective long-term strategy, according to Scott Evans and Paul Marsh of the London Business School in a review of Deutsche Nomis indicators.
In comparison, relying on a small capital premium was much less profitable. The authors say it is reasonable to expect a long-term annual premium of about 1 percentage point with a lot of variation from year to year. The size effect is real, but as an investment formula, it comes up short.
vanessa.houlder@ft.com
