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Just 10 giant U.S. companies now make up one-fifth of the MSCI All Country World Index, the highest concentration in decades. In many parts of the world, large companies ignore their smaller peers. Is the concept of small-cap stocks outperforming, known as the small-cap premium, dead or simply dormant?
The outsized profits of small firms relative to their large peers were documented in the early 1980s using evidence from half a century to 1975. We found theoretical support for this idea. Higher returns compensate investors for taking greater risk in backing smaller, younger companies, but a diversified portfolio can minimize that risk. More importantly, it compensates investors for increased spreads, transaction costs, and increased supervisory costs.
According to UBS's Global Investment Returns Yearbook, small-cap stocks have outperformed large-cap stocks over the long term. Over 43 years in 34 markets, monthly premiums compared to large companies averaged 0.21%. However, the premium identified in the 1980s was much larger. After a period of strong performance, it can disappear for years at a time. This will push down the long-term average.
Short-term economic factors shape sentiment toward small businesses. They are often hit hard during recessions because their revenue streams are not diversified. Smaller business valuations are also more sensitive to interest rates.
By that logic, the prospect of lower interest rates should provide a boost. The boost would be particularly welcome in the UK, where low valuations have made companies a target for takeovers. That being said, index valuations are skewed by those who lose. The FTSE SmallCap Index trades on a price-to-earnings ratio of -139 excluding investment companies.
For the past quarter century, the number of deaths due to takeovers and delistings has exceeded the number of births in the German Numis Small and Medium Enterprise Index. But the ranking of the index, which represents the bottom 10% of the UK's major markets, also jumped due to the “fallen angels” in December's rebalancing. Companies that were previously too large to be included in the index included Watch of Switzerland, Indivior, Ashmore Group and Dr. Martens.
There is also a good chance that the fallen angels will be resurrected. But investors have generally not been successful in betting that underperforming companies will change. In their review of the German Numis Index, London Business School's Scott Evans and Paul Marsh argue that momentum investing, which involves going long on winning stocks and short on losing stocks, is an effective strategy in the long run. He said that.
By comparison, relying on small-cap premiums is much less profitable. The authors say that over the long term, it is reasonable to expect annualized premiums to be about 1 percentage point, with large year-to-year fluctuations. Although scale effects are real, they are insufficient as an investment formula.
vanessa.holder@ft.com
