UBS AM: Smaller companies, larger returns?

The Coronavirus pandemic has had a profound effect on share prices this year, and smaller companies have been no exception. In the first seven months of 2020, the MSCI All Country World Small Cap index (ACWI Small Cap) fell by 8.7%, against the 1.3% drop of the MSCI All Country World Index (ACWI) . Small cap stocks typically deliver higher long-term returns, and we explore why we believe that now is a good time for investors to consider their allocations to small cap.

Small cap stocks have historically performed better over the longer term

There have been many academic studies conducted on the 'size effect' over the past 40 years. Pioneering work by economist Rolf Banz published in 1981 looked at the size effect across US stocks. This was soon followed by the seminal work by Fama and French in 1992 as they introduced their 'three factor model' that explored the performance of the size effect across Value and Growth segments.

The academic research has been supported by the performance of small cap indices over the long term. As the chart below shows, the small cap premium, which is the difference in returns between small caps and the broader market, is 2.4% for the last 20 years.

Performance of smaller companies has historically been better over the long term Index performance – gross returns (%) (Jul 31, 2020)

Lower research coverage creates greater market inefficiency

The size of free float of small companies means it is generally uneconomic for stockbrokers and investment banks to commit resources to analyzing them. For European equities by market cap -- there is a precipitous decline in the number of sell-side analysts covering smaller stocks (See Figure 1 in the full paper). We see the same effect in other regions. The lack of coverage of small cap stocks may also have been impacted by the introduction of MiFID II in Europe, which has driven an even greater focus on the economics of research. We believe this relative lack of information is one of the key reasons for the greater level of small cap market inefficiency. It could provide well-resourced portfolio management teams with a substantial information advantage, in turn enabling them to identify strong investment opportunities.

Broader investment universe and higher active share

One of the key tenets of investment management is that outperformance is a function of manager's skill combined with the breadth of investment opportunities. Assuming a consistent level of manager skill, small cap managers should perform better and provide a higher degree of alpha than managers of large cap portfolios due to their broader investment set. Thus experienced small cap investors may be more likely to avoid companies in structural decline and find companies exposed to fast growing areas, such as e-commerce and educational services.

Small cap indices are less concentrated than large cap indices, with the largest 10 stocks in the MSCI Small Cap Index accounting for only 1.8% of the index's total market cap, while the top 10 companies in the MSCI World Index account for 16.6%. This means that small cap managers typically have a higher active share than large cap managers. This higher differential provides greater potential for alpha generation.

Comparing the performance of small cap and large cap investment managers relative to their benchmarks in both the US and Europe, we see that over the past five years the median small cap manager outperformed their benchmark by 2% in Europe and 0.85% in the US, while the median large cap manager outperformed their benchmark by 1.45% in Europe and underperformed by -0.6% in the US.

Hence, adding better manager performance to higher overall returns increases the return that small cap investors may realize over the long term.

One reason for the better returns may well be the difference in complexity in analyzing stocks. Smaller companies tend to have a narrower, more focused range of business activities than their larger peers and are therefore generally easier to analyze. By contrast, GE for example has 205,000 employees across hundreds of businesses, ranging from health care to energy to jet engines. Developing a deep understanding of the dynamics of a company of such scale is a mammoth task requiring knowledge across multiple sectors.

In contrast, smaller companies tend to operate with fewer, or often single business lines, making the task for an analyst that much easier. While this may not necessarily mean they perform better, it does mean investors seeking to generate alpha from choosing one company over another can feel greater confidence in understanding the dynamics of the business, and therefore hold a higher active share.

Here you'll find the full report 'Smaller companies, bigger returns?'from UBS Asset Management.