Watch out for exaggerated optimism in small caps
Small capitalised companies have been having a great run since the market bottomed in late March. The S&P/ASX Small Ordinaries Index is up 60% since the 24th of March 2020, but by contrast the larger capitalised companies as represented by the S&P/ASX 100 Index is only up 26.2%. The significant outperformance of the smaller companies has ignited renewed interest in this section of the market. In this monthly note we take a closer look at smaller companies.
Figure 1 - A wild ride in equities and even wilder ride in smaller companies
Greater returns but with more volatility
Over the last 20 years smaller companies have outperformed larger companies by almost 0.86% per annum but this outperformance has not been without risk. On average the volatility associated with small companies is 17% compared to larger companies with 13%. This is also evident in the beta of the small company index averaging 114%.
Figure 2 - Longer term return and risk characteristics from Australian Small and
Smaller companies have had a great run in the last 6 months but a quick look at the long term puts that outperformance into some context. Figure 3 illustrates the journey for the last 20 years. The smaller companies have had periods of significant outperformance which is historically followed by periods of underperformance. Depending on when you invest your experience could be quite varied.
Figure 3. Periods of outperformance have historically been followed by periods of underperformance
Valuations are rich in absolute and relative terms
On average over a longer period of time we find the smaller capitalised companies tend to trade at a slightly higher price to earnings multiple and generate slightly lower yields. But this tends to be quite volatile, as during risk on periods they can trade at much higher multiples whereas during risk off this can trade at below average multiples. Currently valuations are stretched for the market and are especially stretched to the smaller end of the index. Most of this has happened in the last 6 months as investors have been willing to price a strong recovery in earnings. It is entirely possible that the economy will recover and many company earnings will return to pre pandemic levels, but if they don’t then this section of the market is more at risk of disappointment. From a relative yield perspective the smaller companies are not as expensive as is implied by earnings multiples.
Figure 4: Smaller Company Valuations
Watch out for overly optimistic earnings especially from smaller companies.
One of the interesting observations about smaller companies compared to larger companies is the investment community is usually overly optimistic on earnings. In the last 20 years expected growth for the next 12 months has averaged +21.1% and yet on average this group of companies has only delivered +13.2%. By contrast the expected growth for larger companies is expected to be lower at only +9.4% and has only delivered +6.8%.2 A much smaller earnings disappointment compared to smaller companies. In both cases analysts’ expectations have been overly optimistic but in the case of smaller companies this optimism is exaggerated.
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Bruce is Head of Active Quantitative Equity - Australia, for State Street Global Advisors. He has over 20 years' experience, covering Australian and global equites, long and short equities as well as global macro strategies.