David vs Goliath - Small-cap investing
Small-cap investing can produce superior returns by allocating to high quality companies with market power and getting aggressive during recessionary periods.
Small cap stocks, the darling of day traders, speculators and investors who aspire quick riches. Intuitively, the allure of small cap investing is obvious: Smaller companies typically have higher growth potential given their size, are unencumbered by legacy systems and practices, and often have charismatic founders. Even history suggests that increasing allocation to small caps will boost portfolio returns: From 1927 to 2014, small-caps have outperformed by 2.94% per year, and have over 74 15-year periods outperformed in 77% of periods. In fact, the smallest cap stocks (in the lowest decile) earned 4.33% more than the market, adjusted for risk.
Table 1: Small vs large Caps across time periods - 88 years (1927 to 2014)
Such performance has contributed to broad acknowledgement of the “Small-Cap Premium”, which reflects the excess returns over and above that of larger stocks to entice investors for the inherent riskiness of small-caps. The small-cap premium typically ranged between 2% to 4% depending on the market capitalization of the firm.
Is it safe than to conclude small caps as an essential source of out-performance? Not quite. Historical evidence supporting small-cap out-performance are laden with inconsistencies, and the winds of change are increasingly turning against David in favor of Goliath.
Small-cap premium matters, only if controlled for junk
In a 2015 paper by Cliff Asness and his colleagues at AQR, they concluded: “The size premium … has a weak historical record, varies significantly over time, in particular weakening after its discovery in the early 1980s, is concentrated among micro-cap stocks, predominantly resides in January, is not present for measures of size that do not rely on market prices, is weak internationally, and is subsumed by proxies for illiquidity.”
They go on to argue that there is in fact a small-cap premium, but only if you control for quality, meaning that high quality (their definition: profitable businesses that display profit growth, safety and have a high payout ratio) small-caps outperform large-caps by a wide margin.
Chart 1: FTSE Russell Indexes Performance (Jun 1996 to Sep 2015)
When accounting for quality and volatility factors, small-caps show a distinct historical out-performance even post-1980s. The Russell 2000 Defensive index outperformed the Russell 1000 Defensive index (10.0% vs 8.2%) which in turn outperformed the Russell 1000 and 2000 indices. Interestingly, companies included in the Russell 2000 Defensive index were on average larger than the Russell 2000 index, showing that it is the combination of quality, volatility and size that matters, not size alone.
The Russell 2000 Defensive index includes about half of the stocks in the Russell 2000 Index, the half with the highest quality and lowest volatility combination. Characteristics include: low earnings variability, low leverage, high return on assets, low 52-week return volatility. The Russell 1000 Defensive index was constructed in the same way as the Russell 2000 Defensive index, except that it selects on the large-cap universe.
Understandably, stocks with very poor quality are typically very small, have low average returns, and are typically distressed and illiquid securities. These characteristics drive the strong negative relation between size and quality and the returns of these junk stocks chiefly explain the sporadic performance of the size premium and the challenges that have been hurled at it.
Cliff Asness found that by controlling for junk, small-caps produce a robust size premium that is present in all time periods, with no reliably detectable differences across time from July 1957 to December 2012, in all months of the year, across all industries, across nearly two dozen international equity markets, and across five different measures of size not based on market prices.
US small-cap premium and the business cycle
Research conducted by FTSE Russell with supplementary data from the National Bureau of Economic Research (NBER), and which covers the past 5 business cycles, shows that Small Caps tend to outperform Large Caps beginning 3 months before the peak and through 12 months into a contraction/recession.
Table 2: Russell 2000 index minus Russell 1000 index forward 12-month returns centered around economic peaks
Chart 2: US Small Cap Premium 12-month forward-looking returns centered around economic peaks, averaged across five recent expansionary periods
The small-cap premiums for the periods of contraction on the right (Table 3) were substantially positive. The average size of the premium increased notably at 3 months after the peak, after the economic downturn began, and was positive in 4 out of the 5 recessions with a hit rate of 80%. The hit rate increases to 100% - five for five – at the +6 month mark, and the average premium size was only slightly lower than at the +3 month point. At +9 months, the hit rate was still high – 80% (4 out of 5) – though the premium size on average declined. The hit rate declined to 60% but the average was still positive – over 7% – at the +12 month mark.
These results seem counter intuitive at first glance, as they suggest that riskier small-caps tend to outperform large-caps during recessionary periods, where the financial resilience of companies is tested.
However, we must be reminded of the forward-looking nature of markets. Markets adjust prices in anticipation of an impending recession, before it takes place. Post-recession price action depends on the recession’s severity vs what was anticipated, and central bank and/or government stimulus measures.
A better explanation of these findings then, is that small-caps under-perform large-caps in the late stages of a business cycle as investors become more risk averse, and only find their footing once the recession is priced in and investment returns to riskier assets. Indeed, investors often look to see if small-cap losses will portend losses for large-caps.
David’s bane – Market Power, Political Power and Economies of Scale
David, great king of Israel, never lived to see the tragedies that befall his nation. From the Assyrian conquest and captivity in Babylon, to the destruction of Jerusalem by Roman Emperors Titus and Hadrian. Among his sins that contributed to Israel’s decline, he stayed small.
History is decorated with the fall of nations, corporations, religions, and ideologies which failed to reach scale and extend their domains. Small-caps today are not exempt and face increasing hurdles to competing with their larger rivals.
Industries are becoming more concentrated. It is not uncommon to see 1 to 4 firms dominate their respective industries. Consider that Amazon owns 44% of all online retail, Google and Facebook own more than half the mobile advertising market, Apple 40% of the US smartphone market, Walmart 21% of traditional grocery, Microsoft 90% of operating systems, and Visa, MasterCard and American Express own almost all of credit card payments.
Table 3: The largest highly concentrated businesses based off 2012 Economic Census
High concentration breeds substantial market and economic power for industry leaders. Which they leverage against their producers, workers, distributors and consumers by negotiating down producer prices, worker salaries, distributor margins and passing down only a portion of their savings to consumers.
These excess profits are in turn channeled to fund new investments in technology that extend their cost advantages, lobby governments on legislature to protect their profits e.g. intellectual property protection and anti-trust laws, acquire smaller firms that may pose a future threat and run huge marketing campaigns that crowds out competitors’ promotions.
Further, large multinationals often have integrated global supply chains, global manpower bases, and multiple tax entities. Allowing them to reduce materials costs, manpower costs, and optimize their tax accounting structures to reduce effective taxes paid.
Small-caps may find it increasingly difficult to compete against their larger rivals and generate return on investments that exceed their cost of capital.
A 1974 Harvard Business Review on market’s share influence on profitability found that market share and return on investment (ROI) were highly correlated. Firms across products and sectors with market shares under 10% earned an average ROI of 9%, while those with market shares over 40% earned an average ROI of 30%.
Chart 3: Relationship between Market Share and Pre-tax ROI
There has been notable decline of new companies formed in the US. From 1995 to 2008, there had been on average 500,000 new businesses formed per year. Since 2010, that number has fallen to 400,000, a decline of 20%.
Recent Small Cap Price and Earnings under-performance
The period beginning 9th March 2011 and ending 9th March 2018, shows out-performance of 17.50% and 15.00% in favor of the large-cap Weighted S&P 500 and Mega Cap Weighted Dow Jones respectively, over the Russell 2000. More recently in 2017, small-caps have under-performed large-caps by 6.32% despite tax reform policies which benefit small-caps disproportionately more than large-caps (which have comparatively lower effective tax rates).
Earnings growth for small-caps has lagged large-caps in each of the past four years and is on track to repeat in 2018. This is further exacerbated by historically high debt levels at small-cap firms because they tend to be more reliant on external capital to grow. If interest rates continue to climb, there are worries some small-caps may fail to refinance their existing debt at sustainable interest rates.
Should we then shun small-caps given their inherent disadvantages?
Not quite. While it isn’t wise to invest in small-cap firms going to market with similar products against entrenched mega firms and hoping to survive, there are small-caps that are creating revolutionary products, opening new categories and leading in niche markets which are out of scope for larger players. Some are in fact monopolies or oligopolies in their respective markets, with sticky customer relationships and great economics.
An example is LRAD Corporation, which engages in the design, development, and commercialization of directed sound technologies and products worldwide. The company’s products beam, focus, and control sound over short and long distances. LRAD has a 90% market share and virtually no competition in long range acoustic devices.
Another perhaps more known example, is Intuitive Surgical, which develops, manufactures and markets robotic products designed to improve clinical outcomes of patients through minimally invasive surgery, most notably with their da Vinci Surgical System. It holds a virtual monopoly in a fast growing and margin-rich business.
Focus on quality, play the business cycle and consider the impact and/or industry factors
Small-cap investments can add significant value to your overall portfolio if you:
Focus on high quality companies with low volatility, high returns on assets, stable earnings and low leverage.
Increase allocation to small-caps during a recession, and reduce exposure later in the business cycle.
Invest in companies with innovative, revolutionary solutions or leaders in niche markets.