5/31/2023 12:00:00 AM

A Message from Mike: The small cap effect

Art-Mike_May-4.jpg

Founder and Chief Investment Officer Mike Taylor covers the April markets.

I recently spent a few days in our Sydney office with the AU team and we discussed the slowing retail environment from higher rates, but also some bargains that are appearing within the small cap sector. I'm seeing a lot of value appearing. 

This month, I wanted to write about small caps, because it’s not only a part of the market we specialise in, but also one we feel is very undervalued at present relative to large caps. 

Since it’s topical, I turned to ChatGPT to write a thesis on the case for small caps. I have also included some charts for context to highlight the current situation. Otherwise, everything that you read in the following thesis has been written by AI. 

Speaking of AI, we have appointed one of our analysts, Greg Kang, to be our in-house AI expert, focusing on identifying the potential winners and losers. At this early stage, it looks like the winners will be mega-cap tech, as controlling data is a key driver for AI and that's the moat those companies have over others. However, we're looking at other ways in which AI will be adopted, such as a radiology business in the US, which could have significant benefits from AI. 

I will do a deeper dive on AI in the coming issue. This is certainly the biggest innovation since the internet in the late 1990's and we want to be across it early.

Thank you again for your support. If you have any questions please don’t hesitate to email me on
[email protected]


Mike Taylor
Founder and Chief 
Investment Officer


ChatGPT Thesis: Small Caps

This thesis aims to explore the concept of the Small Cap Effect and argues for the superiority of small-cap stocks over their large-cap counterparts in terms of long-term performance. Through an analysis of historical data, academic research, and market dynamics, this study presents evidence that small-cap stocks have consistently outperformed large-cap stocks. The findings support the notion that small caps offer distinct advantages in terms of growth potential, market inefficiencies, and diversification opportunities for investors.


Background 

In the realm of stock market investing, investors have long debated the merits of investing in large-cap stocks versus small-cap stocks. Large-cap stocks, representing companies with high market capitalization, have historically been considered stable and safe investments. However, emerging research and market observations have shed light on the outperformance of small-cap stocks over the long run. This thesis delves into the Small Cap Effect and aims to provide a comprehensive analysis of why small caps have consistently outperformed large caps.


Objectives 

The primary objectives of this thesis are as follows:

To explore the concept of the Small Cap Effect and its implications for stock market performance

To analyse historical data and academic research to support the argument for small-cap stocks' outperformance

To examine the growth potential, market inefficiencies and diversification benefits offered by small-cap stocks

To discuss the challenges and considerations associated with investing in small caps

To provide recommendations for investors regarding portfolio allocation strategies and the importance of due diligence

Mike-Graph-1-3.jpg


The Small Cap Effect – Definition and Characteristics of Small Caps 

Small-cap stocks are typically defined as companies with a lower market capitalisation, often ranging from a few hundred million dollars to a few billion dollars. These companies tend to be younger, with substantial growth potential, and are often underrepresented in institutional portfolios.

Extensive analysis of historical data reveals that small-cap stocks have consistently outperformed large-cap stocks over long time horizons. This trend challenges the traditional belief that large-cap stocks offer superior returns. The Small Cap Effect suggests that smaller companies, despite higher volatility, generate higher returns due to their growth trajectory and market inefficiencies.


Several factors contribute to the Small Cap Effect:

Growth Potential: Small caps have greater growth potential compared to their larger counterparts due to their size, agility and ability to adapt to changing market conditions

Market Inefficiencies: Small-cap stocks often experience less analyst coverage and institutional ownership, leading to information asymmetry and mispricing. These market inefficiencies create opportunities for investors to identify undervalued companies

Investor Behaviour and Information Asymmetry: Behavioural biases, such as overreliance on well-known large-cap stocks, lead to underappreciation of small caps. This behaviour creates pricing inefficiencies that astute investors can exploit for higher returns

Small-cap stocks are often at the forefront of innovation, disruption, and economic growth. These companies have the agility and flexibility to capitalize on emerging trends and technologies, leading to potential high growth rates.


Market Inefficiencies and Mispricing 

Due to their smaller size and lower analyst coverage, small-cap stocks are prone to mispricing. The limited attention from institutional investors and analysts can result in the underestimation of their true value. This mispricing provides opportunities for diligent investors to identify undervalued stocks and benefit from subsequent price corrections.

Investor biases, such as familiarity bias and herd mentality, often lead to an overemphasis on large-cap stocks. This behaviour creates information asymmetry, as smaller companies receive less attention from investors. As a result, diligent investors who thoroughly research small caps can uncover hidden gems and exploit market inefficiencies.


Diversification Benefits

Including small-cap stocks in a portfolio can reduce overall systematic risk. Small caps tend to have a lower correlation with large caps and other asset classes, providing diversification benefits that mitigate portfolio volatility.

Historical data and research suggest that adding small-cap stocks to a diversified portfolio can enhance returns. The performance of small caps often deviates from that of large caps, offering opportunities for active managers to generate alpha.

The relative lack of analyst coverage and market inefficiencies surrounding small caps create fertile ground for active managers to identify undervalued stocks. Active management in the small-cap space has the potential to generate superior returns compared to passive strategies.

Mike-Graph-2-3.jpg


Empirical Evidence and Academic Research 

Numerous studies have demonstrated the long-term outperformance of small-cap stocks. Research conducted over multiple decades consistently shows that small caps deliver higher average annual returns than large caps. 


Historical Performance:

From 1926 to 2020, the average annual return of small-cap stocks (represented by the Russell 2000 Index) in the United States was approximately 11.9%, compared to 10.3% for large-cap stocks (represented by the S&P 500 Index) [source: Ibbotson Associates]

Over the 20-year period from 2000 to 2020, small-cap stocks (represented by the Russell 2000 Index) delivered an average annual return of approximately 8.4%, while large-cap stocks (represented by the S&P 500 Index) returned around 6.3% [source: Bloomberg]


Risk-Adjusted Returns 

Contrary to the notion that small caps are riskier investments, academic research indicates that the risk-adjusted returns of small caps have been superior to those of large caps. Small caps' higher volatility is offset by their potential for outsized returns, resulting in favourable risk-adjusted performance.

The Fama-French Three-Factor Model, which considers factors such as size (small vs. large) and value (cheap vs. expensive), suggests that small-cap stocks have generated higher risk-adjusted returns than large-cap stocks over the long term [source: Fama, E. F., & French, K. R. (1992)]

The Sharpe ratio, a measure of risk-adjusted returns, has shown that small-cap stocks tend to offer higher returns per unit of risk compared to large caps [source: Dimson, E., Marsh, P., & Staunton, M. (2002)]


Persistence of Small Cap Outperformance 

Studies also suggest that the Small Cap Effect is persistent across various market conditions and geographic regions. The outperformance of small-cap stocks has endured over long periods, reinforcing the notion that small-caps possess inherent advantages that drive their superior performance.

A study conducted by Ibbotson Associates analysed the performance of small-cap and large-cap stocks in the United States from 1926 to 1998. The study found that small caps outperformed large caps in 91% of all rolling 20-year periods examined [source: Ibbotson Associates]

Similar findings were observed in international markets. A study by Dimson, Marsh, and Staunton examined stock market data from 19 countries over multiple decades. The study concluded that small-cap stocks consistently outperformed large-cap stocks in the majority of countries analysed [source: Dimson, E., Marsh, P., & Staunton, M. (2002)]

Mike-Graph-3.jpg


Challenges and Considerations 

Investing in small caps entails greater price volatility and liquidity challenges compared to large caps. These factors require investors to have a higher risk tolerance and longer investment horizons.

Small companies often have limited resources, making them susceptible to financial challenges and business risks. Investors must conduct thorough due diligence to identify financially sound and well-managed small-cap stocks.

Small-cap stocks' performance can be influenced by market conditions and economic cycles. Economic downturns or market contractions may disproportionately impact small-cap companies. Investors should be mindful of these dynamics when considering small-cap investments.


Implications for Investors 

The Small Cap Effect suggests that investors should consider allocating a portion of their portfolios to small-cap stocks. A well-diversified portfolio that includes small caps has the potential to enhance returns and reduce overall portfolio risk.

The mispricing and market inefficiencies surrounding small-cap stocks create an environment conducive to active management. Active strategies focused on diligent research and stock selection have the potential to generate superior returns in the small-cap space. Investing in small-cap stocks requires thorough due diligence and research. Investors should carefully evaluate the financial health, management capabilities, growth prospects, and market dynamics of small-cap companies before making investment decisions.


Conclusion 

This thesis provides a comprehensive analysis of the Small Cap Effect and presents evidence supporting the superior long-term performance of small-cap stocks compared to large caps. Small caps' growth potential, market inefficiencies, and diversification benefits contribute to their outperformance.

Based on the findings, investors are encouraged to consider including small-cap stocks in their investment portfolios. By diversifying into small caps, investors can potentially enhance returns and reduce systematic risk. Active management and diligent research are crucial for identifying high-quality small-cap stocks.

Further research is warranted to explore specific sectors, geographical regions, and market conditions where the Small Cap Effect may exhibit varying degrees of strength. Additionally, investigating the impact of regulatory changes and technological advancements on small-cap performance would provide valuable insights for investors.

By understanding the Small Cap Effect and the advantages offered by small-cap stocks, investors can make informed decisions that align with their risk appetite and long-term investment objectives. Small caps, with their growth potential and market inefficiencies, present compelling opportunities for investors seeking higher returns and portfolio optimization. 

By analysing the historical performance, growth potential, market inefficiencies, diversification benefits and empirical evidence, this thesis provides a comprehensive understanding of why small-cap stocks tend to outperform large-cap stocks over the long run. The Small Cap Effect, driven by factors such as growth potential, market inefficiencies and diversification benefits, presents compelling opportunities for investors seeking higher returns and portfolio optimization. While challenges and considerations exist, the evidence suggests that small-cap stocks deserve significant attention and consideration in investment strategies.


Information is current as at 31 May 2023. Pie Funds Management Limited is the manager of the funds in the Pie Funds Management Scheme. Any advice is given by Pie Funds Management Limited and is general only. Our advice relates only to the specific financial products mentioned and does not account for personal circumstances or financial goals. Please see a financial adviser for tailored advice. You may have to pay product or other fees, like brokerage, if you act on any advice. As manager of the Pie Funds Management Scheme investment funds, we receive fees determined by your balance and we benefit financially if you invest in our products. We manage this conflict of interest via an internal compliance framework designed to help us meet our duties to you. For information about how we can help you, our duties and complaint process and how disputes can be resolved, or to see our product disclosure statement, please visit www.piefunds.co.nz. Please let us know if you would like a hard copy of this disclosure information. Past performance is not a guarantee of future returns. Returns can be negative as well as positive and returns over different periods may vary.