Micro or mega cap, which is the most attractive?
2022 has been a rocky year for the majority of investment asset classes. One area that has had it particularly rough is the smaller end of the share market. Across most global share markets small caps have underperformed large caps this year. Academics, Fama & French, famously identified in their 1992 study that smaller caps outperform the general share market over the long-term. Their findings morphed into what many in the market now refer to as the “small cap risk premium”, essentially shorthand for saying that small caps are riskier than large caps and investors should be rewarded with higher returns for taking on that extra risk. 2022 appears to have been an episode of small cap investors experiencing that extra risk.
However, before delving into this notion that smaller caps are riskier, let’s take a closer look at what determines which class of market cap a company falls into. A company’s market cap is the current share price multiplied by the number of shares on issue. As the table below shows, investment convention has created several strata of different market caps, from Mega to Nano.
Table breaking down the different market capitalisations
The table above uses US$ as the currency to denominate the various levels of market cap. At the top of the pile are Mega Caps, the monsters of the share market. New Zealand does not have any Mega Caps and for that matter neither does Australia, albeit BHP Group with a market cap of US$160 billion is not a million miles away. In fact, New Zealand doesn’t currently have any Large Caps with our largest company, Fisher & Paykel Healthcare, now having a market cap of US$8 billion. By global standards the S&P/NZX 50 index can be very much considered a Mid Cap centric benchmark. Furthermore, about a dozen of the companies that make up the S&P/NZX 50 index would currently fall into the Micro Cap category. And then right at the bottom of the scale we have Nano Caps with market caps of less that US$50 million, where we find Burger Fuel Group with its lowly $15 million market cap.
The table has one other column of information, pertaining to the random stock examples for each category, which has the number of broking analysts that cover each company. Unsurprisingly, the number of broking analysts researching each company drops as the market cap drops. For broking firms to justify the expense of employing an analyst to cover a company they have to believe that they will have clients that use that coverage to either purchase or sell shares in that company. Coverage is also useful in securing investment banking business from a company. Mega Caps receive a high level of coverage because an extremely large number of clients are likely to trade shares in that company and the company is also potentially a very lucrative investment banking client. The column clearly shows the dramatic drop off in broker coverage as market cap shrinks. Smaller companies have less potential to generate commission for brokers and do not offer the same potential for investment banking services. Frankly less investors hold Small and Micro Caps and those companies just do not do large acquisitions that excite investment banks.
This drop-off in broking coverage represents both an opportunity and a risk for the active investor. Let’s start at the top of the pile, literally dozens of analysts pore over every detail that could help assess the value of the Walmarts and Estee Lauders of the share market. That’s a lot of very smart people tasked with a very specific job. Then combine that with the tens of thousands of investors that trade those shares every day in what should be a really good attempt at accurate price discovery. Which altogether should mean that at the big end of town the relationship between share price and value should be pretty tight, most of the time. Mispricings can obviously still occur but tend to be more related to short lived episodes of widespread panic, March 2020 for example, or negative company specific news that damages short term earnings, to which investors often overreact to.
The picture changes a lot as you move down the market caps. Suddenly broker coverage drops to half a dozen for a typical Mid Cap and even less for Small Caps. Price discovery for these smaller companies involves far fewer investors than the Mega and Large Cap space. The potential for dislocation between share price and value has literally sky rocketed. It no longer needs an episode of extreme market fear or bad company specific news for these companies to be mispriced. However, it can swing the other way too, these companies can at times be ridiculously overpriced. Not that long ago a raft of early-stage technology companies were almost certainly massively overpriced relative to their value. This potential for large mispricing at the smaller end of town is a deterrent to a great deal of investors who would rather stick to the “safer” larger caps. However, for the active investor that does their own research and doesn’t rely on broker recommendations the smaller caps represent a fertile hunting ground for companies trading well below their true value. It should also be noted that for the brave that delve into the Micro and Nano Caps there are a large number of companies that have only one broker or not even one providing an assessment of their value. This probably represents the share market’s best chance at being able to buy a company at a fraction of its future worth. However, as Fama & French noted, it comes with some extra risk because when fear hits and the market wants to get risk off, smaller caps generally underperform in the short-term. But in the longer term investors, especially those that do their own research, benefit from exposure to mid and smaller caps.
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Stephen has over 25 yrs investment experience & co-founded Castle Point, a NZ boutique fund manager, in 2013. Prior to that he worked at funds management companies in Auckland, London & Edinburgh. Castle Point WINNER FundSource Boutique Manager 2019
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