Small CapsFeb 6 2017

Small caps make a safer bet long term

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Small caps make a safer bet long term
Monthly net retail flows into the IA North American Smaller Companies sector

After a strong run in US small-cap stocks in 2016 that sent the Russell 2000 index up 21 per cent, investors are once again faced with the question: is it still appropriate to overweight small- and mid-cap stocks?

It is an understandable query given the huge 926 basis points (bps) of outperformance small caps experienced versus large caps in the past 12 months, but the emphatic answer for any long-term investor should be a resounding ‘yes’.

From a quantitative perspective, most investors are aware of the large body of research highlighting that small-cap stocks outperformed their large-cap peers over the 55 years between 1928 and 1983. The data becomes even more compelling when some sensitivity to value is employed. But it is important to remember that the outperformance spanned a wide range of interest rate environments, tax and trade policies and an assortment of US presidents. 

 Small caps are likely to receive an outsized benefit from any tax reform that a new US administration might put in place

The strong performance of small caps in 2016 also came on the heels of an unusually long 10-year period of underperformance – 2005-15 – when the US large-cap Russell 1000 index posted a 7.3 per cent gain versus the Russell 2000’s 6.6 per cent. Last year could then plausibly be viewed as a simple catch-up after an anomalous period of large-cap strength.  

Small- and mid-cap stocks have generally maintained their strong returns since the 1983 studies, and have continued to deliver outsized gains over the long term. In addition to the historical data, there are a few more intuitive reasons as to why small caps make sense for long-term investors. 

First, large mature businesses have a much harder time growing revenues at a high rate than small- and mid-cap names. In the past 15 years, revenues from Russell small-cap firms have grown significantly faster than large caps. Second, small and mid-sized companies typically have a greater likelihood of being acquired or taken private than their large-cap peers. This is especially true if investors focus on the kind of underleveraged high-quality stocks that private equity investors love to purchase and then lever up. Third, small- and mid-cap names operate in less-efficient markets and are much more sparsely covered by Wall Street analysts, providing a real opportunity to find high-quality businesses selling at a discount to intrinsic value. 

Lastly, while future US tax policy is still far from certain, the average tax rate paid by small-cap firms is a lofty 32 per cent versus just 26 per cent for S&P 500 companies. Small caps are likely to receive an outsized benefit from any tax reform that a new administration might put in place.

For investors outside the US, small-cap exposure may be even more critical for the purposes of diversification. In aggregate, 44 per cent of the total revenue of S&P 500 firms comes from abroad. For particular subsectors of the large-cap benchmark, such as energy and technology, the share of foreign US revenue is even higher, at 58 per cent. For small caps, on the other hand, just 19 per cent of revenue is generated from sales outside the US, giving investors more direct exposure to the country’s economy. 

Sceptics are quick to point out that the added return from small caps comes with additional risk. For retail investors, and in fact for many institutional investors, this increased volatility is often greater than they are willing to bear, and simply increases the odds that they sell their small-cap equity positions at exactly the wrong time. The bad name that active management has received over the past several years notwithstanding, this is where a sound strategy of active stockpicking within the small-cap universe comes into play.

Careful analysis of individual firms should enhance returns above the benchmarks over a full market cycle by identifying high-quality, small-cap issues that have stronger free cashflow generation, better balance sheets, and some competitive advantage or defensive characteristic. These stocks are admittedly fewer and farther between for small caps, but the faithful adherence to a strategy like this can reap great rewards in the space and should realise lower levels of downside risk.

A high-quality focus should provide the additional benefit of helping to prevent the type of irrational selling behaviour that often plagues many investors. 

By definition, owning a basket of thousands of small-cap companies requires owning all of the expensive, overleveraged, and secularly challenged businesses along with the higher-quality ones. An active approach to small- and mid-cap firms at minimum should help to avoid low-quality value traps, and at best should identify a group of companies that have qualities that both enhance returns and minimise the risk of small and mid caps over a full market cycle.

Attempting to predict exactly how small caps will fare relative to large caps in 2017 is a challenging game to play, but if investors take a defensive approach to small caps for the long run, they will surely be rewarded.

Alec Perkins is a portfolio manager at Perkins Investment Management