We are in an era of modest investment returns. Unprecedented Central Bank policy responses to the financial crisis have significantly distorted financial markets. Interest rates are zero (if you’re lucky) and bond yields are not much higher. The valuations of real assets such as equities and property have also been affected, and while they may not be overvalued (as bonds are), their valuations are elevated, particularly as there is precious little sign of inflation or real growth in the world.
Investors have turned to alternative classes in search of growth. However, many of these alternatives such as Private Equity, Hedge Funds, Infrastructure and Absolute Return Funds have disadvantages including liquidity issues, high costs, and lack of transparency. We believe that in this era of modest returns Small & Mid Cap Equities can deliver growth for investors over time, without many of these disadvantages. In our view the growth potential here is higher than equities in general and raises the question whether small & mid cap equities should be regarded as a distinct asset class in their own right.
The Historic Record
Small caps have a strong historic record of outperformance. Research by economists Dimson & Marsh of the London Business School shows that $1 invested in US large cap stocks in 1955 would have grown to $3,919 (including the benefit of dividend income reinvested) by 2013 whereas $1 invested in small caps would have grown to $29,400.(1)
This is not just a US phenomenon as other research shows such outperformance is common in many developed economies. Indeed, the track record is so strong and so widespread it has its own name: “The Small Company Effect”.
Why the Outperformance?
There are numerous factors which underpin the outperformance of smaller stocks.
Firstly, smaller companies have greater growth potential as the relative opportunities are larger – growing market share from 1% to 5% is proportionately higher growth than growing from 50% to 60% share. Geographic growth can be a substantial growth driver if a domestic business model can be successfully rolled out internationally, while smaller companies have greater opportunity to make transformational acquisitions.
Smaller companies are more nimble and responsive – they have greater scope for self-help. They tend to be more innovative and they can adapt to challenges and change more flexibly and quicker than larger companies.
Thirdly, having managers who think like owners is a key factor – and often senior management own material stakes in small stocks. Having ‘skin in the game’ certainly aligns the interests of managers with the interest of shareholders, whereas executive compensation schemes in large cap companies are often based on metrics which are not proven to create sustainable long-term value for shareholders.
Smaller companies are also more likely to become M&A targets for growth-constrained large caps with strong balance sheets. In a low growth environment, the ability for companies, particularly those with access to low-cost debt, to enhance growth through acquisition is even more attractive. As an example, since we launched our Appian Small Companies Opportunities Fund (ASCOF) four years ago, we have been surprised by the intensity of takeover interest among the stocks in the Fund. Fourteen stocks owned by the Fund have been acquired by other corporates over the four years, which is a high number in the context of a concentrated fund which generally owns only 25-35 holdings.
These factors support the view that there is a sustainable structural opportunity in small & mid caps. While there are times when small cap valuations can significantly lag those of large caps (and the small cap opportunity is enhanced during these times), the track record of the Small Company Effect is, we believe, too strong over too long a time scale to be driven by periodic valuation anomalies.
Be Wary of the Small Cap Indices
There is a strong investment case for small cap investing. However, ‘benchmarks’ or passive investing are not the best ways to capture the opportunity. Many small cap indices are poorly constructed and in our opinion contain too much ‘junk’.
An occupational hazard in the small cap arena is that the indices include many high risk stocks. Some of these are concept stocks, oil & gas explorers or early stage biotech research companies which can potentially offer very high rewards if they succeed, but have a high risk of failure if they don’t. Others are just low quality companies, maybe with unsustainable business models, weak management teams or too much debt.
The major risk with small company investing is corporate failure. The permanent loss of capital from any position, even in a well-diversified portfolio represents a significant headwind to achieving the target return for an investment portfolio.
Active Approach Can Enhance the Opportunity
Active stock selection in the small cap arena we believe is a better way to capture the opportunity. An active approach can minimise the risk from the ‘junk’ included in benchmarks and consequently can reduce risk and enhance potential return.
Appian applies a disciplined investment process in our ASCOF. We aim to avoid loss-makers, cash burners, concept companies, start-ups and highly indebted stocks. We seek to identify high quality companies, the hallmarks of which include:
- solid balance sheets;
- strong and persistent returns on capital – which is a good indicator that a business has a sustainable competitive advantage;
- healthy cash generation – which can support investment in future profitable growth by the company and / or a healthy dividend profile;
- motivated management team with a good track record;
- and a clear and realistic strategy for sustaining and growing the business.
Research by Asness, Frazzini et al (2) illustrates how quality is a particularly powerful factor in small cap investing. Their research shows that the Small Company Effect is more pronounced, more robust and more stable when controlling for quality/junk.
We believe this can be enhanced by combining a bias to quality with a rigorous approach to valuation. Buying high quality companies on attractive valuations in our view is a strong foundation for generating good investment returns over time. Quality companies have a stronger chance of delivering, and if their achievements are not recognised by investors in the valuation of that company then it is likely to be only a matter of time before a third party recognises it. That fourteen of the ASCOF’s holdings have been taken over by corporate buyers over the four years since its inception is in our view a function of owning quality companies at attractive valuations.
Another key component in our active approach is regular engagement with the management teams of the companies we invest in. Investor research on smaller stocks is not as widespread or as deep as on large companies. Consequently, there is greater chance that smaller companies may be mispriced by the market. Regular management meetings help us uncover quality companies whose prospects may be undervalued by the market, and sometimes also highlight risks that are not fully appreciated in the market’s view of a stock.
Better Outcomes – Lower Correlation, Higher Returns
The ASCOF has grown by 82% over the four years from its launch. Our first graph illustrates that small caps have outperformed general equities over that period (as measured by the 71% growth MSCI ACWI Small Cap Index versus the 44% gain in MSCI World index in euros), but also that the ASCOF has performed better than the small cap index (82% versus 71%), underscoring the potential for an active approach to outperform the poorly constructed benchmarks in the small cap arena.
Our second graph below tracks the volatility of the ASCOF and the same two indices. Interestingly, the volatility of the small cap index is not materially different from that over the overall equity index, which is consistent with small cap indices only having a slightly lower correlation to overall equities returns. However, the volatility of the ASCOF is clearly lower than both indices for large parts of the period and its volatility did not increase as much as that of the indices as the period progressed. This illustrates that a disciplined active approach in small caps can be less risky (taking volatility as a proxy for risk) than benchmark tracking and can deliver a lower correlation to overall equity performance.
Are small caps an asset class in their own right? The relatively high correlation with mainstream suggests not.
However, what is clear is that an active approach in this segment has been superior to any index-based approach. As the track record of the Appian Small Companies Opportunities Fund shows (and the graph below highlights this), a disciplined quality approach delivers superior results both in terms of higher returns and lower risk.
1 Dimson, Marsh & Staunton (2002), Triumph of the Optimists (Princeton University Press), and updated in subsequent research
2 Asness, Frazzini, Israel, Moskowitz & Pedersen (Jan 2015)
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The ASCOF is a sub-fund of the Appian Unit Trust (Prospectus available on request). The value of investments can fall as well as rise. Past Performance is not a reliable guide to future performance. If you invest in the Appian Unit Trust you may lose some or all of the money you invest.