Capturing the small cap premium
The outperformance of small cap stocks relative to their large cap brethren over extended periods has given rise to a belief in the ‘small cap premium’.
Convincingly established by many historical studies, the continuing persistence of this premium is underpinned by the continuing persistence of the institutional biases that give rise to it.
The academic and investor Bruce Greenwald in his book, ‘Value Investing: From Graham to Buffett and Beyond’, captures this point particularly well: “Market capitalisation is an important explanatory factor of outperformance independent of value-oriented ratios. That is, the stocks of small companies have out-performed the shares of large companies even when the price-to-book ratios are similar (see Fama articles). Size matters, and smaller has been better most of the time. Fundamentally, because they are not acceptable to a large part of the investor universe, small caps tend to be a bargain until they grow bigger.”
While the theoretical case for having exposure to small caps in order to benefit from this premium is compelling, the challenge of achieving this exposure is in practice daunting for many investors. The universe is vast. There are currently more than 4,300 stocks in the MSCI World Small Cap Index. Breaking this vast choice down into a credible group of potential investments is just the first step.
With their more limited access to capital markets, individual small cap stocks are generally riskier than their large cap counterparts; the usual dangers of concentration are magnified in small cap portfolios.
The author and economist John Kay has a house in France, which necessitates him driving regularly on their wonderful AutoRoute network.
In promoting his new book ‘Other People’s Money: Masters of the Universe or Servant of the People’, he has been retelling a story about the driving habits of many of his fellow AutoRoute users.
Many of these drivers follow what Kay calls a tailgating strategy in getting from A to B on the AutoRoute. In order to shave journey time they drive very close to the car in front. Consequently, the vast majority of the time they succeed in arriving at their destination sooner, while very occasionally but often catastrophically, they crash and cause one of those horrendous pile-ups which are a rare but shocking feature of driving in France.
In the aftermath of such a pile-up, there is always a proximate cause offered as an explanation – mechanical failure, driver error, tyre issues or whatever – while the real cause is the tailgating strategy which will inevitably result in a pattern of many small (time) gains followed by a dramatic and likely catastrophic loss (pile-up).
Bill Miller was a famed concentrated stock-picker who achieved legendary status in the investment world by beating the S&P 500 index of US stocks for 15 consecutive years between 1991 and 2005. However, his experience of then losing all of this cumulative outperformance between 2006 and 2008 is of more relevance to investors. In the context of driving on the AutoRoute, the equivalent of mechanical failure, driver error, or tyre issues clearly struck.
Miller’s portfolio always ran the danger of being proved fragile. He ran the risk of something happening that would have a severely negative impact on performance. He ran the risk of allowing time to be an enemy of his fragile portfolio of stock-picks, despite his confidence in their individual merits.
As an investor, it’s impossible to know beforehand which outcome will be enjoyed or suffered. We do know, however, that any given concentrated portfolio is fragile to an unknown negative in a disproportionate way relative to a less concentrated counterpart.
The diversified and dividend oriented solution
The risk of concentration is greater for the small cap investor. However, in order to move away from this risk, the conventional case against diversification – that it stymies potential alpha – needs to be debunked. The downside protection benefits of broad diversification can be enjoyed without giving up the potential to harvest lots of alpha. The case is illustrated by the chart (see below), showing the 24 MSCI industry groups and their performance in the Small Cap universe over the past three years.
Source: Thomson Reuters Datastream, Kleinwort Benson Investors, as of 30 September 2015 ($, MSCI World Small Cap)
The white boxes show the index or market-cap weighted returns for each group. Most managers spend a great deal of time tilting between these boxes in the hope of capturing alpha – being over-weight media, under-weight energy etc. In doing so, they are necessarily becoming more concentrated in their exposure and are adhering to the conventional wisdom that in order to out-perform – you must become more concentrated, give up some of the downside comfort of diversification, and take on more concentration risk. This is a damaging myth.
To see why, consider the dark green lines showing the dispersion of returns within each industry group, effectively the spread between the winners and the losers; in every case, this is markedly greater than the differences between them.
This confirms the tantalizing prospect of being able to construct very broadly diversified portfolios, benefitting from all of the downside comfort implicit in that, whilst also being able to harvest lots of potential alpha.
The small cap premium is persistent and is likely to continue. However, with concentration a greater danger in small caps, investors have a clear need for a diversified solution to gain exposure to this premium.
Given the huge dispersion of returns within industries and regions, the opportunity to achieve this diversified exposure while maintaining the potential to gain lots of alpha, is a clear and attractive one.
Small caps don’t (or can’t) issue bonds to the same extent as large caps. When they do, their credit ratings are generally lower, making the cost of this debt generally higher. This also feeds into their generally aggressive tendency to issue more shares. Indeed, small caps often have little alternative than to get shareholders to fund them, regardless of the prevailing cost of equity.
For these reasons, a process with a very definite dividend orientation is particularly beneficial. By enforcing greater capital discipline and management focus on returns, rather than size, a dividend oriented process is likely a greater necessity and benefit in constructing small cap portfolios.
In summary, the need for both a more diversified and dividend oriented solution to capture the small cap premium is compelling.
John Looby is portfolio manager, Global Equities Strategies at Kleinwort Benson Investors