Small caps outperform over the long term

Several studies have found that small cap companies can outperform large cap companies. Fama and French in 1992 and 1993 found that small cap companies had a higher ending value for the past 51 years. Rob Arnott, Feifei Li, and Geoffrey Warren noted a statistically significant size performance advantage over 10, 20 and 50 year periods ending in 2007 in their in their “Clairvoyant Value and the Value Effect” paper published in the Journal of Portfolio Management, Spring 2009 issue. The size effect seems to compound over time, providing a 30% gain over ten years and a four-fold increase in value over 50 years from 1957 to 2007.

Small caps 1

 

Small caps

 

Source: Journal of Portfolio Management, Volume 35, Number 3 Spring 2009 – Clairvoyant Value and the Value Effect

Investors also can benefit from diversification and positive active management effect by investing in small caps. Gregory C. Allen concluded that outperformance by average small cap equity managers represented an opportunity for investors to benefit from consistent active management gains. Allen measured outperformance against the Russell 2000 over the last 20 years ending in 2005 using a Callan Associates database. Only 20% of the outperformance was attributed to managers waiting to have a three year track record to report performance in consultant databases. Survivorship bias, which involves only including managers that have strong performance given lack of information on underperformers, was considered and did not explain outperformance. Persistency bias, which implies that managers share commonalities including expenses and investment style over time, showed up in the study but did not explain outperformance either. Rob Arnott, Feifei Li, and Geoffrey Warren offer a note of caution in their Fall 2013 “Clairvoyant Discount Rates” paper: small cap stocks tend to have larger return dispersion among each other and winners tend to be universe outliers.

Morgan Stanley advocates underweighting European small caps

Morgan Stanley analysts believe that small caps are more expensive relative to large caps. Mid and small cap outperformance relative to large caps is close to levels seen in 2009, during the early part of stock market recovery. Matthew Garman and his European strategy analyst team found that underperforming stocks’ market cap is at a record relative low. Underperformers appearing in multiple sell screens had just 35% of market cap of the average stock listed in the MSCI Europe index. Matthew Garman points out underperformers have been within this size range four times and in each case small and mid caps underperformed by an average of 6.5% over the next six months. Underperforming stocks included are Banca Popolare di Milano (BIT:PMI) (OTCMKTS:BPMLF), Banco Popolare Societa Cooperativa (BIT:BP) (OTCMKTS:BPSAY), Banco Popular Espanol SA (BME:POP) and Banco de Sabadell SA (BME:SAB) (OTCMKTS:BNDSY) and all have market caps below USD$15 million.

Small Caps chart

Source: Morgan Stanley, Bloomberg, Factset, Worldscope and MSCI

Small caps market capitalization

Source: Morgan Stanley

Even though Morgan Stanley’s analysis focuses on the short term, it points out the importance of stock selection in the mid to small cap space. This is consistent with the notion of dispersion introduced by Rob Arnott, Feifei Li, and Geoffrey Warren in 2013.