The small cap premium – down but not out

Historically, over the long term small caps deliver higher returns than large caps, but the past decade has seen a trend change driven by mega caps. There is evidence, however, that the small cap premium is still important

Eugene Fama winning the Nobel Memorial Prize in Economic Sciences 

In 1906 during a country fair in Plymouth, Sir Francis Galton asked several hundred people to guess the weight of an ox. None of them got the answer right, but incredibly, the average of the guesses was remarkably close to the actual weight. It was a phenomenon that became known as the ‘wisdom of crowds.’

Several decades later, Nobel laureate Eugene Fama took inspiration from Galton in his 1970 work on the Efficient Market Hypothesis, which states that share prices are accurate reflections of all relevant information and are therefore not over or undervalued. The implication was: you can’t ‘beat the market.’ But does this always hold true?

Over the past decade, rises in American large cap indices have been fuelled by mega caps. Vast network effects created by their market leading, scalable offerings have erected a barrier to entry for smaller competitors. There’s plenty of potential left in some of these ‘modern monopolies,’ which have a place in our portfolio.

Historically, however, small cap long-term returns are superior to those of large caps. According to the Ibbotson SBBI dataset, the annual yield of US small caps beat large cap returns by 1.7 percentage points over the 1926 to 2022 timeframe. For someone investing $1 in 1926, this translates into a return of $49,052 on small caps, compared to $11,535 for large caps.

For some time, large caps bucking this long historical trend was mainly a US market phenomenon. European small caps (particularly in Sweden) have performed strongly until recent years, when a change became apparent here, too. Is the shift permanent? Or do small caps still yield a premium, and if so, how can investors profit?

Small cap characteristics
The term ‘small cap’ usually implies a capitalisation in the approximate range of $250m–$1bn. Index suppliers use their own criteria, often some percentage of total stock market cap. The median component of Russell 2000 – the small cap index most commonly used in the US – has a market cap of around $1bn; Russell 2000 is comprised of the 2,000 smallest companies in the Russell 3000 index, which in turn includes the 3,000 largest US shares. S&P Small Cap 600 omits unprofitable companies, resulting in more of a quality tilt.

The performance of small caps relative to large caps will revert to its historic trend

In Europe, the most common broad small cap index is MSCI Europe Small Cap, which includes 1,000 listings. There is a plethora of local market indices, such as the Swedish Carnegie Småbolagsindex, used as a benchmark by many small cap equity funds here. This index includes listed shares with a market cap of less than one percent of Nasdaq Stockholm.

The sector representation in small cap indices differs from that in large cap indices, affecting quality and valuation measures. These sector differences are also very important to adjust for when comparing small caps to large caps in a particular market, as well as when comparing small caps across geographical markets.

The small cap market captures investor interest for a number of reasons that we shall look at.

Growth potential: Finding a share that rises very significantly is much more likely among small caps than among large caps. One obvious factor is that small cap growth starts from a smaller base – achieving exceptional share price growth is harder for mega caps with a market cap running into hundreds of billions or even trillions. The high-growth prospects among small caps lure many investors, but picking winners is not that easy, as many younger small cap companies are more financially vulnerable through economic downturns.

Dispersion: Unlike large cap indices, small cap index developments don’t hinge on the success or failure of a handful of large companies. The 10 largest index components comprise 20 percent of MSCI World, but only three percent of Russell 2000. The vastness of the small cap universe yields a wide range of quality and growth attributes.

Sector representation (which affects quality) varies among small cap indices on different markets. The percentage of higher-quality companies in small cap indices relative to large cap indices is larger in Europe (particularly in Sweden) than in the US. Over time, 10–20 percent of small cap indexes have consisted of companies with declining profits. This ratio is usually smaller in Europe than in the US, reflecting differences such as the US small cap biotech sector with its many unprofitable hopefuls.

Generally, the quality level of small caps indices has declined somewhat in recent years. This development further boosts the importance of selectivity and active management.

Liquidity: Smaller company shares are often significantly less liquid than large company shares, hampering market participation for large investors and hedge funds, which in turn keeps liquidity subdued. Theoretically, higher transaction costs and lower liquidity motivate a liquidity risk premium in small caps. Financial information from and equity analyst coverage of smaller companies is also lower compared to large caps. Due to lower market transparency, inefficiencies and asset mispricing can provide opportunities for small cap investors.

The small cap premium debate
The long-term yield advantage of small caps versus large caps is well established. But are small cap yields superior even when adjusting for risk exposure?

The existence, size and causes of the small cap premium have been fiercely debated. The Capital Asset Pricing Model (CAPM), developed in the 1960s, posits that yield expectations reflect the risk level of an asset relative to that of the market portfolio, as expressed by the asset’s beta value. According to CAPM, superior yields on small caps merely compensate for a higher beta value, so there is no advantage in risk-adjusted returns. CAPM and the ‘efficient market’ theory have not fared too well. In 1981, economist Rolf W. Banz showed that the superior relative returns of small caps cannot be explained merely by CAPM beta – there is an additional small cap premium. Further risk factors have been identified over the years. The Fama-French three factor model of 1992 comprises market risk, a small cap premium and a value premium. The small cap premium actually has quite narrow support in the Banz study. It has also declined over time – due to increasing investor interest, it has been suggested.

In recent years, however, a number of interesting academic studies by Clifford Asness and others have shown that the small cap premium still exists at a significant level when adjusting for quality. If loss-makers and low-quality companies are eliminated, the small cap premium is alive and well, in a somewhat modified form. Note that within small caps, the value segment has developed better than the growth segment in eight out of 10 decades. The larger prevalence of lower-quality loss-makers among growth companies is a likely explanation.

A market suited to active managers
For maximum alpha, investors want to employ highly proficient asset managers who are active in less efficient markets. High outcome dispersion translates into more opportunities to pick winners and avoid losers. Richard Grinold’s ‘fundamental law of active management’ uses the terms ‘information coefficient’ (managing skill) and ‘breadth’ (opportunities to put the skill into good use).

In general, the dispersion is far higher among small caps than among large caps (particularly outside the US). Emerging markets, tech and biotech are other high-dispersion areas of particular interest to active managers. Institutional investors and analyst forecasts are relatively less common on the small cap market. It can take the small cap market longer to price new information, and the resulting inefficiencies favour investors who do their own fundamental analysis.

Small cap exposure
In our view, the performance of small caps relative to large caps will revert to its historic trend. Strategically, equity portfolios should have ample small cap exposure. Limiting investments to large caps excludes considerable growth potential – the small cap exposure of MSCI ACWI, a global index, is zero.

Portfolio share: The share of small caps in an equity portfolio will be governed by return targets and risk tolerance. Small caps make up 14 percent of the broad global index MSCI ACWI IMI, which includes 99 percent of global equity market cap. It is reasonable for investors to hold about 15 percent of a global equity portfolio in small caps with diversification across sectors and regions.

Active, lean management: Small cap index investing is best avoided – studies show that filtering out low-quality companies is key to achieving a significant small cap premium. Some smart beta funds do this. We prefer skilled, active managers, with geographic market specialisation and an AUM in the lower range. Research has shown that alpha generation ability scales badly, as funds grow too large to trade in less liquid assets. When selecting a fund, check on its size when the track record was accumulated – the game plan may have changed.

Portfolio allocation: Structurally, private investors with a long-term investment horizon do not need the high daily liquidity available in large caps that some large institutional investors require, and can benefit from the small cap premium over time.

However, many small caps are less global and more exposed to their domestic economy than multinational large caps. It follows that cyclically, small caps can be more impacted by domestic monetary policy tightening and sharply higher interest rates such as we are now experiencing in the US and Europe. Given that a downturn for 2023 was widely expected, small cap absolute valuations are already quite low. Furthermore, relative to large caps, small cap valuations in Europe and the US are also historically quite low. As markets work through this cyclical downturn, there are both relative and absolute opportunities to consider small caps