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Just 10 U.S. giants now account for a fifth of the MSCI All Country World Index, the highest concentration in decades. In much of the world, large companies have left their smaller counterparts in the dust. Is the idea that minnows outperform – known as the small-cap premium – dead or simply dormant?
The outsized returns of small businesses relative to their larger counterparts were documented in the early 1980s using data dating back half a century to 1975. The idea found theoretical support. Higher returns compensate investors who take higher risk by backing smaller, younger companies – although this can be minimized in a diversified portfolio. More importantly, they reward investors for higher spreads, trading fees, and higher supervision costs.
Over the long term, small-cap companies have outperformed larger ones, according to the UBS Global Investment Returns directory. Over 43 years and across 34 markets, the monthly premium over large companies averaged 0.21 percent. But the premium identified in the 1980s was much larger. It can disappear – sometimes for years – after periods of good performance. This lowers the long-term average.
Short-term economic factors shape sentiment toward small businesses. They are often hit hard by recessions because they have less diversified sources of income. Smaller company valuations are also more sensitive to interest rates.
By this logic, the prospect of a rate cut should provide a boost. A boost would be particularly welcome in the UK, where low valuations make companies takeover targets. That said, the valuation of indices is distorted by losses. The FTSE SmallCap Index trades on a price-to-earnings ratio of minus 139 if investment companies are excluded.
Over the past quarter century, “deaths” from buyouts and delistings have exceeded “births” in the Deutsche Numis Smaller Companies Index. But the ranks of the index, which represents the bottom 10 per cent of the main UK market, were also inflated by ‘fallen angels’ during its December rebalancing. Companies previously too big for the index included Watches of Switzerland, Indivior, Ashmore Group and Dr Martens.
The Fallen Angels might just bounce back. But generally speaking, investors haven’t prospered by banking on underperforming companies to get them to change. Momentum investing – investing in winning stocks and shorting losing stocks – has been an effective long-term strategy, according to Scott Evans and Paul Marsh of London Business School in an analysis of Deutsche Numis indices.
In comparison, relying on the small-cap premium has proven far less profitable. It’s reasonable to expect a long-term annualized premium of about 1 percentage point with plenty of variation from year to year, the authors say. The size effect is real but as an investment formula, it proves insufficient.