Blog 70: Small Cap Investing…….When Small Is Big!

Blog 70: Small Cap Investing…….When Small Is Big!

Welcome back to Informed Decisions, Ireland's only dedicated Financial Planning Blog & Podcast. Hope you are winning! When it comes to investing there are many folks that have no interest in what they are investing in, provided it makes them a decent return and it doesn't disappear over-night!

Others like to take a closer look at their options, to think about portfolios and what they should be doing. They might like to identify what will work for them as a suitable portfolio, to figure out if there is anything they could invest in that they had not previously heard of or been aware of much. This episode is for these types of people! (not to suggest that the 'other type' aren't welcome to keep reading!).

What is Small Cap Investing:

This is investing some (or all) of your cash in what the industry terms as 'Small Cap Companies'. These are companies which typically have a value or Market Capitalisation (number of shares * price of each share) of between €200m and €2billion. While the name suggests they are small companies, they certainly aren't small, they are just small in comparison to Large Cap/Big Cap companies. Looking at the Irish Stock Exchange (ISEQ) we can see that the majority of the companies listed on it are of total value (Cap) of less than €2bn, hence being classified as Small Cap. It is only the like of Tesco, Ryanair, Glanbia, Kerry Group etc that are in the Large Cap category.

You can, of course, buy a share(s) in the Small Cap company, directly owning a single piece of that company. Alternatively you can invest in an index or a fund that invests in these Small Caps on a larger scale. In a Small Cap Index such as the Dimensional International Small Cap Growth Portfolio, you could see over 1,500 different companies being invested as part of that single index.

Fundamentally, Small Cap Investing is investing in these 'smaller' companies. It is a deliberate approach to investing. Instead of investing in a single, or group of large companies you are tactically investing in the smaller ones. This leads us to ask the following....

Why Invest In Small Caps?

One would assume that if deliberately investing in ANYTHING that there is a logic to it, a rationale in taking that action. It's slightly off-topic but it never ceases to amaze the things that people invest in for no apparent reason. Perhaps they are convinced or fooled-into doing it, or perhaps they are looking to invest as a means to provide some entertainment for the themselves. Either way it is our belief that there really ought to be a rationale for investing in something, there ought to be a goal, an objective by which you can measure the success of the approach over the long term, otherwise it's likely to not deliver the result you want.

Anyway, in looking at the returns of Small Cap versus the rest of the equity market it is quite interesting to see how they perform. In one piece of research by Dimensional Fund Advisors, an Investment Firm with approx 100 funds available and who manage €400 billion, the results were pretty stark!

They tracked and researched the illustrative performance of Small Caps across various geographical regions over various periods of time, to determine what level of returns Small Cap deliver in comparison to the rest of the market. It is important to note that they tracked a Small Cap Index in each region versus a 'whole market' Index in that same region over this period of time. This essentially meant that they were in a position to compare two large groups of shares, with no 'active management' to give a true representation of Small versus Large.

UK Returns: Over the period of 1970 to 2016 their Small Cap Index delivered 15.27% returns per year while the MSCI UK INdex (which tracks the Large & Mid Cap companies in UK) delivered 11.10% per year. That is over 4% greater returns from the Small Caps, per year!

To put these returns into context, an investor who invested €50,000 into the Small Cap index in 1970 now has €34.5m...........by doing absolutely nothing other than leaving it there for 46 years, and not reacting when the markets do. Why do people feel the need to invest in single stocks when this level of return has been achieved!?

European Returns: Over the period of 1981 to 2016 the European Small Cap Index delivered 11.83% annual return versus 9.79% from the MSCI Europe Index. Again, 2% more per year from the Small Cap Index.

While not as mind-blowing as the UK Returns, had an investor placed €50,000 into the UK Small Cap Index in 1981, and done absolutely nothing for 35 years, her €50,000 would now be valued at €2.5 million.

US Returns: The data for US goes back to 1928, allowing the research to span a period of almost 90 years. The same trend applies over this period as it did in the periods already covered. From 1928 to 2016 the annual return for the US Small Cap was 12.15%, while the S&P 500 (The largest 500 listed companies in US) delivered 9.75% per year. Here we see an even larger gap between the performance, at almost 2.5% in favour of the Small Caps.

Just for fun we've calculated that a €50,000 investment in 1928 in the Small Cap Index would now be valued at................................€1,205,885,677, or €1.2 billion in plain english!!

Emerging Market Returns: Emerging Markets is the term given to less well established or 'developed' countries in terms of their economy and markets. It is a slightly misleading term because the Emerging Countries have been 'Emerging' for years, but anyway, the main countries of the Emerging Markets are Brazil, Russia, India and China.

The Emerging Markets Small Cap delivered 11.41% per year from 1989 to 2016, while the MSCI Emerging markets Index delivered 9.6% over that same period. Here we see the narrowest gap in regards return, with the Small Cap 'only' outperforming the Large Caps by 1.8%. A €50,000 investment in 1989 would now be valued at €924,000 thanks to the 11.41% growth per annum average.

The evidence is clear that Small Cap Index have delivered a permium over Large Caps. Large Caps have performed superbly well on average, no question, however there has been a considerable benefit in being invested in Small Caps over these periods, and in all of the goegraphical regions.

What Are The Risks Of Small Caps?

Small Caps probably get a lot more negative coverage and therefore a lesser reputation than the larger ones. Some say that Small Cap companies are more prone to fraudulent activity, to lower quality outputs and to lesser transparency. It is hard for anyone to say that Large Caps don't often succumb to such failings also!

A Small Cap may have a smaller customer base than the Large Caps, or it may operate in a niche area or industry. As a result of this, like any small business you can think of, its cash-flow and overall success can be quite volatile. This can impact on the share-price and it's overall standing on a regular basis, or at least more regularly than it may in the case of a Large Cap company. It is also fair to say that the risk of a business going 'out of business' may be higher if the company is small. There may be less in reserve, less backers and less transparency or understanding.

So how much more volatile are Small Caps versus Large Caps. At a European level it is interesting again to compare the frequency at which Small Caps beat Large Caps over rolling periods. In the period of 1981 to 2016 again Dimensional have shown that Small will beat Large in the majority of cases over various rolling periods. In that period of time there are 420 overlapping 1-year periods in their research, and the Small Caps beat the Large Caps in 61% of these periods. There are 313 over-lapping 10 year periods, and Small beat Large in 73% of these periods.

Irrespective of the risks, with many of the Small Cap Indexes tracking well in excess of 1,000 different companies, the major exposure of a company going 'bust' is hugely minimised, and which ultimately has led to the beautifully rewarding returns over the long term.

Whats The Bottom-Line:

Someone looking-in might say that you'd have rocks in your head not to go all-in on Small Caps. They might suggest that Large Caps do not deliver the same returns as Small Caps so by-pass them altogether. They may be right, but we don't know what the future brings. It might also make sense to harness the power of Small Caps, but to do so in conjunction with a well diversified chunk of Large Caps to keep a level of balance to things.

If nothing else the research shows that Small is beautiful!

Thanks for reading. Please share & talk about us!

You're a Legend,

Paddy Delaney

QFA | RPA | APA | Qualified Coach

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