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Harry Nimmo, Head of Smaller Companies. Why should investors in smaller companies expect a higher return? What are the risks involved? And what are the opportunities for active managers? In this piece, we set out the historic strong performance of smaller companies.
We 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. And we highlight the opportunity for active management. For investors looking for a deeper understanding, 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. These include higher credit costs, different country and sector exposures, and lower average levels of profitability. And we review academic studies of smaller companies, finding anomalies that active investors can aim to exploit.
We finish with a brief history of smaller-company investing. Why should investors consider allocating money to smaller companies? Why should they expect a higher return? And what are the risks involved? Chart 1: Cumulative historical performance of US small-caps and large caps, Smaller companies raced ahead between and , attracting the attention of academics and investors.
The composition of small-cap indices was changing. The globalization 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.
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 are also large in number. Smaller companies outperformed in 25 of the 28 countries see chart 4. The fundamental explanation for the small-cap premium is that the stocks of smaller companies are higher risk.
Returns are higher but so is the volatility of returns. Instead, successful investing requires a deep understanding of these risks and the potential rewards that they offer. 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. The magazine stated that the majority of these stocks were either total failures or frauds. Since its launch in , over 3, companies from across the globe have chosen to join AIM. Long-term investors might use a less favorable description. From its launch to the end of , the index has underperformed fully listed smaller companies by 8.
Underperformance was even greater between and the launch of AIM, at 9. Of course, there is one very notable exception. And it offered additional tools and services to connect with shareholders. This paper 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.
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. 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.
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. 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. Today there are fewer fad stocks. There are now a number of profitable companies with good business momentum listed on the exchange. 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. What are the higher risks that explain the small-cap premium? And what characteristics explain why smaller companies perform differently than their larger peers? 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 larger. Investors also need to understand the risks that are neither greater nor 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. 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 riskier company will have the smaller market capitalization. Does Size Really Matter? 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 toward 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. 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. Smaller companies have historically underperformed from the peak of an economic cycle to its trough see chart 6.
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. The cost of borrowing is higher for smaller companies. 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. 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. The risks above translate into higher volatility of returns for an index of smaller companies than their larger peers. Big companies are complex organizations. Sony grew rapidly in the second half of the 20th century on the back of sales of Trinitron TVs and the Walkman. By the s, the company had become a bloated behemoth, employing , people. 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. 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. Together they represent a combined 7. Smaller companies have a higher proportion of domestic sales, while larger companies include more multinationals.
Stock-specific risks are a more significant driver of performance for smaller companies than their larger peers see chart 8. By contrast, larger companies are more sensitive to other factors such as country, sector and style. 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.
This overlap is illustrated in the Venn diagrams below see chart 8. 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.
Portfolio managers still need to account for 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 credit market neatly boils the risks of a company down into a single number: the credit spread over government bonds. The bond yield had to be available on Bloomberg. We plotted the bond spread against the equity market capitalization, for both investment grade corporate bonds and high yield corporate bonds see chart Log scales for both the credit spread and market capitalization help illustrate the relationship.
The charts demonstrate that smaller companies are priced as higher risk by the market: the credit spread increases as market capitalization decreases. Smaller companies are in general less profitable than their larger peers. They also have lower debt ratios. The smaller companies index has higher weights in real estate and industrials. The larger companies index has higher weights in financials and information technology. By contrast, there is little difference between country weights.
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 to In only one year in 11 did smaller companies outperform large in every region In no year did they underperform in every region.
Where are the opportunities for active managers to add value when investing in smaller companies? And how does this differ from their peers investing in larger companies? There are fewer investment banking analysts per company for small companies than large. This is due to the combination of a larger number of companies and their lower market capitalization. Lower capitalization means lower share turnover, which translates into lower revenue for the investment bankers.
Here there are 23 analysts covering large-cap companies on average compared to seven for small-caps. One year after the new regulations took effect, a Numis study of the UK smaller-companies market looked at the effect on analyst coverage. An earlier Numis study found that broker recommendations on small-cap stocks added value. There was one exception: stocks with just one recommendation. By contrast, this was not the case for large-cap stocks. The stocks of smaller companies also have a wider range of investment outcomes, from best to worst performer.
This reflects a wider range of fundamental outcomes. Smaller companies have more scope to grow. The small-cap research that is available is often much shallower. This information gap opens up opportunities to find compelling investment ideas that others have yet to discover. Three trends are combining to leave an increasing portion of the equity market under the management of passive or quantitative investors.
First, the shift in assets from active to passive management has been a pervasive theme among large-cap portfolios. However, it is less significant for smaller companies, although it is growing from a low base. The fee differential between passive and actively managed equity funds is less stark for smaller companies.
Fidelity recently made headline news by offering two zero-fee funds to US investors. Second, smart-beta products are growing in popularity, with investment decisions driven by quantitative models. Many products include a tilt to smaller companies or size factor, alongside value, quality, momentum and low volatility strategies.
The cost of gathering and processing data has fallen. The number of investment professionals with quantitative skills has risen. These quants can rapidly turn the latest academic research into investment practice. However, anomalies that can be exploited by fundamental analysis persist among smaller companies. This is, in part, due to higher trading costs and limited scope to implement short positions.
Third, there has been a growing role for macro managers. They typically buy and sell index products to implement their trading views. They often ignore smaller companies altogether. If they do invest in smaller companies — long or short — it is typically to take a view on the relative merits of smaller companies versus large. Together, these trends mean managers who do not analyze individual companies play a growing role in the market.
This may increase the scope for stock-pickers to add value through fundamental analysis. The author Harry Nimmo has a strong track record of investing in smaller companies — one that stretches over more than two decades. Many institutional investors follow the advice of investment consultants. Consultants help their clients design and validate their long-term investment strategy. This important and influential group of advisors has systematically over looked the opportunities within the large investment universe of smaller companies.
A style analysis of a typical actively managed equity portfolio would show an overweight to smaller companies. A typical fund is underweight the very largest companies in an index. And, when permitted, these funds own a handful of the largest smaller companies. Roderick Louis Paris. William Regnar Littleboy. Brian Joseph William Fleming. Jan Felix Freund. Anne Kathryn Breen. Philip David Laing. Gordon Lowson. In The News. The New York Times. Investment Adviser. SLI raids Alliance Trust for investment trust head.
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