Why should investors in smaller companies expect a higher return? What are the risks involved? And what are the opportunities? In this four part series, we set out the historic strong performance of smaller companies, describe the fundamental drivers of their above-market returns and the risks involved. We explain the different risk exposures that create the opportunity to add value through portfolio diversification. For investors looking for a deeper understanding of smaller companies, we explore the history of poor performance of junior stock markets and the opportunities that arise as they mature. We dig deeper into the differences between large and small cap exposures, review academic studies of smaller companies and look at anomalies that investors can aim to exploit.
Smaller companies are too big a portion of the global investment universe to ignore. They offer a return premium for long-term investors. They bring diversification benefits through exposure to different risks. A large universe and fewer analysts combine to provide scope for active managers to outperform the index.
The Investment Opportunity
Above-market returns from a broad and deep investment universe
The Center for Research in Securities Prices at the University of Chicago Booth School of Business provides the longest history of size-ranked stock indices.
A dollar invested in US larger companies in 1926, with dividends reinvested, grew in value to $5,767 by the end of 2017. A similar investment in small-caps grew to $38,842, over six times more.
A 2% per annum return premium translates into a significant sum when compounded over a number of decades.
Smaller companies raced ahead between 1975 and 1983, attracting the attention of academics and investors. Between 1984 and 1997, the ‘small-cap premium’ turned negative, leading investors to question the higher return produced by investing in smaller companies over large. Instead this difference was rebranded the ‘small-cap effect’, reflecting that smaller companies performed differently to large, sometimes lagging and sometimes leading.
Chart 1: Cumulative performance of US small-caps and large caps, 1926-2017
Source: Professors Dimson, Marsh, Staunton and Evans, London Business School, CRSP, Morningstar 31 December 2017
The poor performance during the 1980s and ‘90s was not just the unwinding of a crowded trade. The composition of small-cap indices was changing. The globalisation of manufacturing was transforming the investment landscape. Industrial production was shifting from the developed world to the emerging world. Small-cap indices started to fill up with fading manufacturing companies.
Similarly, the recovery since the turn of the century has occurred against the backdrop of improving fundamentals. Small-cap indices have benefited from the strong performance of companies that have captured the growing opportunities created by technological advances.
Small companies – big investment universe
Smaller companies represent a greater proportion of the world index than any single country outside the US. They also represent a higher weight than the combined emerging markets. They account for 13% of the MSCI All Country (AC) World IMI Index.
Chart 2: MSCI All Country World IMI Index, by market capitalisation
Source: MSCI, 31 December 2018
This index captures 99% of the global equity investment opportunities, across 23 developed markets and 24 emerging markets, including large and small-cap stocks. They are also large in number. Splitting this index by company size, the MSCI AC World Small Cap index has 5,967 constituents. By comparison, the MSCI AC World index (of large and mid-cap stocks) has 2,758 constituents.
Source: MSCI, 31 December 2018
Smaller companies premium – a global perspective
Rolf Banz, a PhD student at the University of Chicago, first identified the small-cap premium in US stocks in 19813. This triggered similar studies around the world. In a 2018 study, Professors Dimson, Marsh and Evans from the London Business School provided a global perspective. They calculated the small-cap premium to be 5% per annum for the largest 28 countries in the FTSE World Index between 2000 and 2017. Smaller companies outperformed in 25 of the 28 countries (see chart 4).
Source: Professors Scott Evans, Paul Marsh and Elroy Dimson, Numis Smaller Companies Index 2019 Annual Review, 31 December 2018
Smaller companies effect – understanding the risks
The fundamental explanation for the small-cap premium is that the stocks of smaller companies are higher risk. Returns are higher but so too is the volatility of returns. There is no ‘free lunch’ available simply by buying a smaller companies index. Instead, successful investing requires a deep understanding of these risks and the potential rewards that they offer
Digging deeper: The maturing of junior stock markets
Junior stock markets have a poor reputation. Lower barriers to entry provide smaller growing companies with easier access to capital. However, these lower barriers also represent higher risk for investors. And higher risks do not always translate into higher returns.
In 1989, Forbes magazine labelled the Vancouver Stock Exchange (VSE) the “scam capital of the world”. An alternative to the major Toronto Stock Exchange, it operated between 1906 and 1999. It featured many small mining and oil & gas exploration stocks. The magazine stated that the majority of these stocks were either total failures or frauds.
“Out of 1,205 mining companies on the VSE, only 50 actually produced minerals, and only 10 to 15 are profitable.”
AIM, the London Stock Exchange’s alternative investment market, describes itself as “the most successful growth market in the world. Since its launch in 1995, over 3,600 companies from across the globe have chosen to join AIM.”
Long-term investors might well use a less favourable description. The Numis Alternative Markets Index includes all AIM-listed stocks. From launch to the end of 2017, the index has underperformed fully listed smaller companies by 8.6% per year. This index has a back-history dating to 1980, incorporating stocks traded on the now discontinued Unlisted Securities Market (USM) and Third Market. Underperformance was even greater between 1980 and the launch of AIM, at 9.5% per year.
NASDAQ: the poster child of secondary stock markets
Of course, there is one very notable exception. The New York-based NASDAQ may be America’s second stock exchange, but it is also the second largest stock exchange in the world by market capitalisation. Launched in 1971 and opened as an electronic exchange in 1981, it has attracted some of the world’s most successful companies. It is home to all of the FAANGs, the tech giants that led stock market performance in 2017: Facebook, Amazon, Apple, Netflix and Google (via the listing of its parent company, Alphabet). In 2017, PepsiCo switched its listing from the New York Stock Exchange to NASDAQ after nearly 100 years on the primary exchange. The company told investors that a NASDAQ listing was more cost efficient. And it offered additional tools and services to connect with shareholders.
The success of NASDAQ has attracted many imitators. “Worldwide by 2015, over 130 new junior stock exchanges in over 70 countries had formed”, according to Professors Robert Eberhart and Charles Eesley, authors of The Dark Side of Institutional Intermediaries: Junior Stock Exchanges and Entrepeneurship.
This series provides a number of findings that help explain why stocks listed on junior stock markets have generally performed poorly. These exchanges lower the barriers to entry on a variety of measures: company size, growth, profitability and stability. “This results in higher failure rates of the listed firms and the frequent failure of the junior exchange itself.”
The lowering of reporting standards leads to greater asymmetry of information. Easing the access to capital for the entrepreneur increases the uncertainty that investors face. Without the ability to carry out proper due diligence, investors fund less worthy firms.
Many of these exchanges were launched to promote the formation of new technology firms. The increased supply of capital to that industry led to the funding of more marginal firms, creating greater competition. The authors studied the performance of over 19,000 companies listed on the MOTHERS exchange and NASDAQ Japan (subsidiaries of the Tokyo Stock Exchange and the Osaka Exchange). They found that “annual growth in revenues decreased by an average of 5.9% for technology companies compared to non-technology firms”. “In sum, the new junior stock exchanges facilitated investment into new technology ventures to the detriment of their prospects.”
Simple analysis can help overcome some of the risks associated with a lightly regulated environment, such as the AIM market. Chris Mallin and Kean Ow-Yong studied Factors influencing corporate governance disclosures: evidence from Alternative Investment Market (AIM) companies in the UK. “We report clear evidence that compliance increases with company size, board size, the proportion of independent non-executive directors, the presence of turnover revenue, and being formerly listed on the Main Market. However, we find that shell and highly geared AIM companies disclose relatively lower levels of corporate governance than recommended under QCA* guidelines.” This provides a clear list of factors for a fundamental analyst to assess.
How has NASDAQ succeeded against this backdrop? It introduced a tiered listing standard. Standards strengthen for companies as they move up from the bottom to top tier.
The success of companies in the top tier, such as Apple and Microsoft, provide credibility and legitimacy to the exchange.
*The QCA, or Quoted Companies Alliance, is an independent membership organisation that champions the interests of small to mid-sized quoted companies.
AIM: a maturing market
There are signs that the AIM market has matured too. Prior poor performance was mostly linked to recent initial public offerings (IPOs) and fad businesses. In particular, the TMT bubble around the turn of the century and the ‘commodity supercycle’ of the last decade led to many low quality IPOs. At the end of 2010, the oil & gas sector and mining sector together accounted for 46% of the AIM 50 index. By December 2017 the two largest sectors were pharmaceuticals and general retailers, which together represented 31% of a more diversified index.
Today there are fewer fad stocks. Many stocks pay dividends: 68% of the AIM 50 index in December 2017 compared to just 16% in December 2010. There are now a number of profitable companies with good business momentum listed on the exchange.
Chart 5: Proportion of profitable and dividend paying companies on AIM (% by value)
The lower barriers to entry of junior exchanges mean that investors should always apply higher levels of due diligence. But the maturing of these markets is creating opportunities. Selective stock pickers can identify attractive investments, backed by solid fundamentals.
Don’t miss out on our Small Cap Series
Over the coming weeks we will explore the risks of small cap investing, the opportunities available to investors and conclude with a deep dive on the Australian small cap landscape. Click ‘follow’ below to be the first to read the next installment.
I have one caveat, and that is, I always invest in a company, after much research, and do not worry about such things as a generality like a "small cap landscape". If after research, I still like the company, I buy it, end of story. Cheers, Eric Wells