Smaller companies have delivered strong performance since the turn of the millennium, yet the asset class remains under‐researched by academics. The little research that has been done offers encouragement to stock pickers. It also offers insights to asset allocation strategists considering their exposures to smaller companies.
US smaller companies raced ahead between 1975 and 1983, attracting the attention of academics and investors around the world. Between 1984 and 1997, the ‘small‐cap premium’ turned negative, leading investors to question the existence of a return premium from investing in smaller companies relative to large. Instead this difference was rebranded the ‘small‐cap effect’ by academics, reflecting that smaller companies performed differently to large – sometimes lagging and sometimes leading.
The recovery from these lows has attracted less attention. However, a 2018 study from Professors Evans, Marsh and Dimson of the London Business School provided a global perspective. In The Numis Smaller Companies Index 2018 Annual Review, they calculated the small‐cap premium to be 5% per annum for the 21 largest countries in the FTSE World Index between 2000 and 2017. Smaller companies outperformed in 19 of the 21 countries.
A search of the Financial Analysts Journal going back to 2000 reveals just four papers on smaller companies. Each provides an interesting angle for active investors.
Profiting from index rebalancing
Long‐Term Impact of Russell 2000 Index Rebalancing (2008) by Jie Cai and Todd Houge examined the performance of companies added to and removed from this most widely followed index of US smaller companies. They found that a portfolio ignoring changes and following a buy‐and‐hold strategy outperformed the rebalanced index by over 2% per annum from 1979‐2004. The authors established that index deletions had provided significantly higher returns than index additions (adjusting for factor exposures).
They explain that “Part of these excess returns can be explained by strong short‐term momentum effects. Stocks with good performance grow too big for a small‐cap index and continue to have superior performance after being deleted from the index; stocks with poor performance become small enough to enter the index but continue to generate low returns.”
Active managers who were not forced to instantly adjust their portfolios in response to index changes were able to benefit from this. The strongest‐performing funds held onto stocks that had been deleted from the index, avoided index additions, or both. The authors concluded that “index methodology may provide a structural incentive for portfolio managers to drift from their benchmarks”.
Extracting value from the ‘accruals anomaly’
Investors in smaller companies can exploit the ‘accruals anomaly’ to deliver outperformance. A seminal paper written by Professor Robert Sloan in 1996 identified that investors were overly focused on the bottom‐line earnings, without sufficient consideration of the quality of those earnings. This left scope for investors to outperform by favouring companies where more of their earnings came in the form of cash flow rather than accrued income.
This anomaly was an example of a market inefficiency rather than a structural risk premium. Once it had been identified and codified into trading algorithms, it largely disappeared. However, The Accruals Anomaly and Company Size (2008) by Dan Palmon, Ephraim Sudit and Ari Yezegel found that this opportunity persists for smaller companies, where higher trading costs meant the anomaly had not been arbitraged away.
Finding value (and other factor returns) in smaller companies
Active investors in smaller companies can exploit the full range of return premiums on offer in markets. Indeed, Disentangling Size and Value (2005) by Rob Arnott found that ‘When the size effect is separated from the value‐versus‐growth effect, size as measured by market cap is seen to be far less powerful than is generally believed and the value effect becomes more powerful and more consistent than generally believed.’ In other words, much of the historic premium return from smaller companies comes from the fact that these stocks are cheaper, rather than because they are smaller.
Beyond the Financial Analysts Journal, The Numis Smaller Companies Index 2018 Annual Review found that momentum, low volatility and income strategies have also provided long‐term excess returns to investors in smaller companies, alongside value.
Information in international flows
For asset allocators considering an exposure to smaller companies, they need to understand that the small‐cap premium can be strongly influenced by international investor flows. The Impact of International Institutional Investors on Local Equity Prices: Reversal of the Size Premium (2011) by Hau Jiang and Takeshi Yamada analysed the period between 1995 and 2008 when the size premium went into reverse in Japan. They observed that international institutional‐investor ownership of Japanese shares increased threefold over this period, with these investors showing a preference for large‐cap stocks. In some ways, Japan is a special case, as its economy was in a very different cycle for much of this period. However, with Brexit, the election of a populist government in Italy and President Trump pursuing an America First agenda, country‐specific risk is very much back on the agenda.
Investors can look beyond dedicated smaller company research for useful lessons. Mononationals: The Diversification Benefits of Investing in Companies with No Foreign Sales (2017) by Cormac Mullan and Jenny Berrill reveals its conclusion in its title. A portfolio of companies with domestic‐ only sales offers an antidote to the integration of financial markets. Mononationals are primarily all smaller companies.
Of course, the small‐cap premium has not been ignored by the investment community. Instead it has been embraced by a new breed of investors: quant investors employing smart beta strategies. The flow of money into these strategies has been one ingredient in the outperformance of smaller companies since the turn of the millennium. However, these investors are typically buying every index constituent.
For active managers willing to undertake fundamental research, the growing portion of passive and quantitative portfolio management provides greater scope to add value above the index return.