What are the higher risks that explain the small-cap premium? What characteristics explain why smaller companies perform differently from their larger peers? In the second installment of our four part series, we look into understanding the risks factors that are common to all companies, large and small, explain some of the return premium characteristics and explore the potential benefits of small cap diversification.
Risk and return are two sides of the same coin. Academic studies have tried to identify the higher risks involved in investing in smaller companies. These help explain why investors should demand a higher return. Less noticed are the risks that are lower for smaller companies than large. Investors also need to understand the risks that are neither greater not smaller but simply different. These provide a source of diversification. Finally, investors cannot ignore the risk factors that are common to all companies, large and small.
A smaller company can have a lower market value for two reasons:
- it is small (which investors can measure in a number of ways)
- or it is relatively risky.
Investors should apply a higher discount rate to future cash flows of more risky companies. A higher discount rate means a lower valuation. In other words, for two companies with the same annual sales, the more risky company will have the smaller market capitalisation.
Does Size Really Matter? by Professor Jonathan Berk looked at the performance of smaller companies classified by factors other than market capitalisation, such as annual sales. Using these other measures, he found that returns were unrelated to size. The relative riskiness of smaller companies is the dominant factor in explaining the observed relationship between market value and returns. Understanding these risks is key to understanding the value of the company.
In general, academics explain the small-cap premium as the reward for accepting the poor performance of smaller companies during periods of market stress. Active investors must decide if they are being adequately rewarded for this risk. Or they can decide to control these risks, for example by tilting portfolios towards higher quality companies.
In summary, an investment in a smaller companies index is higher risk than the equivalent larger companies index. But investing in a smaller companies portfolio does not have to be.
#1 - Liquidity risk
The shares of smaller companies are less liquid. They also have higher insider ownership, leaving a smaller free-float for external shareholders. This risk can be mitigated in a portfolio context. However, it translates into a higher cost for entering and exiting positions.
#2 - Recession risk
Smaller companies have historically underperformed from the peak of an economic cycle to its trough (see chart 1). For the US equity market, this underperformance was 5% on average during the five recessions that have occurred since 19809. A longer view captures the Great Depression (1929-1933) and the deep recession of the 1970s (1973-1975). These were periods of significant pain for holders of smaller companies.
Chart 1: US Small-cap relative performance and US recessions, 1926 - 2017
Source: Professors Dimson, Marsh, Staunton and Evans, London Business School, CRSP, Morningstar, NBER, 31 December 2017
This analysis is based on perfect hindsight of when recessions began and ended. In practice, there is a long lag between the start of a recession and its identification. We associate recessions with bear markets. But here too, investors require hindsight to identify the start of a bear market. Nor do economic downturns and market downturns neatly coincide. This helps explain the somewhat counterintuitive findings of a Numis study: UK smaller companies outperformed in bear markets but underperformed in recoveries (see chart 2).
Chart 2: When do small caps do well?
#3 - Credit risk
The cost of borrowing is higher for smaller companies. (Indeed the cost of equity is higher too. Lower average valuations for share buyers translate into higher cost for the companies issuing those shares.) This is consistent with the underperformance of smaller company shares when times are tough: during recessions.
The small-cap premium is higher when rates are low than when they are high. And higher when interest rates are falling than when they are rising.
#4 - Inflation risk
Equity market valuations are higher when inflation is close to target. They are lower in periods when inflation is high, or when inflation falls close to zero or turns negative (deflation). This pattern is exaggerated for smaller companies. This means the small-cap premium is higher when inflation is close to target but lower during periods of low or high inflation.
#5 - Price volatility
The risks above translate into higher volatility of returns for an index of smaller companies than their larger peers.
#6 - Complexity
Big companies are complex organisations. Sony grew rapidly in the second half of the 20th century on the back of sales of Trinitron TVs and the Walkman. By the 1990s the company had become a bloated behemoth, employing 160,000 people. With profits under pressure, the company divided into smaller units, asking each to focus on their own profitability. In 1999, one unit launched the company’s first portable digital player at a trade fair in Las Vegas. Next on stage was a rival product from a competing Sony unit. Not surprisingly, consumers were confused and both failed. The complexity of large companies makes it harder for management to be in control.
#7 - Index concentration
The composition of market indices reflects past success. Sometimes one theme dominates the market, leading to a concentration of stocks at the top of the list. Today, five US technology companies head the MSCI World Index: Apple, Microsoft, Alphabet (which owns Google), Amazon and Facebook. Together they represent a combined 7.5% of the index. This concentration increases in regional portfolios and is yet more pronounced in single country portfolios. For example, Samsung Electronics represents 28% of the MSCI Korea Index. A few large stocks can skew the overall performance of market-cap weighted equity portfolios.
#8 - Currency exposure
Smaller companies have a higher proportion of domestic sales while larger companies include more multinationals. For example, domestic sales account for 63% of total sales for companies in the MSCI US Index. This compares to 78% of sales for companies in the MSCI US Smaller Companies Index. This means small and large companies have different responses to currency moves.
#9 - Stock-specific risk
Stock-specific risks are a more significant driver of performance for smaller companies than their larger peers (see chart 3). By contrast, larger companies are more sensitive to other factors such as country, sector and style.
Chart 3: Stock specific risk as percentage of total risk
Source: Axioma, 31 December 2018
#10 - Different companies
A portfolio of smaller companies is a different set of companies to a portfolio of larger companies. This might seem too banal to mention. Yet investment in factor-driven (or smart beta) portfolios is growing and can lead to the same stocks appearing in more than one factor sub-portfolio. For example, 55 of the 151 companies in the iShares Edge MSCI USA Value Factor ETF are also included in the iShares Edge MSCI USA Size Factor ETF. This overlap is illustrated in the Venn diagrams below (see chart 4).
Chart 4: Index overlap: number of stocks
Source: MSCI, ISHARES, 31 December 2018
#11 - Long-cycle performance
These different risks help explain why capturing the small-cap premium involves periods of outperformance and underperformance. The cycle between small-cap and large-cap leadership differs across different countries. These cycles can last for a number of years.
#12 - Traditional risk measures
Portfolio managers still need to take account of country, sector and industry exposures. They need to understand their exposure to style factors, such as quality, momentum and value. And, in particular, they need to be aware of the stock-specific risks. These are best understood through fundamental analysis. In conclusion, investors must understand the complex set of risks associated with smaller companies. But it is this understanding that provides the opportunity for active managers to deliver performance.
“The stocks of smaller companies have a wider range of investment outcomes, from best to worst. This reflects a wider range of fundamental outcomes.”
Beyond size: Digging deeper into the differences
How does a portfolio of smaller companies differ from a portfolio of larger companies? We provide facts and figures to illustrate the differences. We look at borrowing costs, company fundamentals, country and industry weights, analyst coverage and regional performance differences.
The credit market neatly boils the risks of a company down into a single number; the credit spread over government bonds. We identified companies included in the MSCI US Smaller Companies Index which also had a corporate bond. (The bond yield had to be available on Bloomberg.) We plotted the bond spread against the equity market capitalisation, for both investment-grade corporate bonds and high-yield corporate bonds (see chart 5). Log scales for both the credit spread and market capitalisation help illustrate the relationship. The charts demonstrate that smaller companies are priced as higher risk by the market: the credit spread increases as market capitalisation decreases.
Chart 5: Interest rate spread versus market capitalisation
Source: Bloomberg, 31/01/2018. For illustrative purposes only. No assumptions regarding future performance should be made.
Smaller companies are in general less profitable than their larger peers. They also have lower debt ratios.
Source: Worldscope/Factset, December 2018
Country and industry weights
There are notable differences in sector exposure between the MSCI AC World Index and the MSCI ACWI Small Cap Index (see chart 6). The smaller companies index has higher weights in real estate and industrials. The larger companies index has higher weights in financials and information technology.
Chart 6. MSCI World Index and ACWI Small Cap Index Sector Weights
By contrast, there is little difference between country weights. The smaller companies index has a 4% lower exposure to US stocks and 3% higher exposure to Japanese stocks. But all other differences are less than 1%.
44% of companies included in the MSCI ACWI Small Index have seven analysts or fewer. This compares to 13% of companies in the MSCI AC World Index.
Source: Thomson Reuters Datastream, Data 31st December 2018
The smaller companies effect is not a global phenomenon. We compared the performance of large and small companies in five regions. We looked at calendar years from 2007 to 2017. In only one year in 11 did smaller companies outperform large in every region (2011). In no year did they underperform in every region.
Source: Thomson Reuters, December 2018
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.