Blink 182’s pop-punk anthem filled the dancefloor of my student union’s most popular weekly night. In those hazy years(!) my formative interest in economics and investment began.
One of the first investment learnings was around the haloed small cap effect. Small caps are perceived as inherently riskier than their larger counterparts. A combination of variable growth rates, lower liquidity, substantially reduced sell side coverage (all versus large or mega caps) and reduced access to capital markets should lead to greater inefficiencies and require an extra premium to own.
Over time, this premium should lead to higher expected returns. So why have small cap returns been so lacklustre in recent years?
Lights turned off
In the past few years and in most major markets, small cap returns have been trounced by their larger peers. Smaller companies on aggregate are more economically sensitive than larger multinationals, therefore a difficult economic environment can lead to meek returns.
Small Cap VS Large Cap
Source: Lipper for Investment Management, Total Return, GBP, 30 April 20241
Despite the US economy continuing to grow strongly, its small cap market has the joint weakest returns, relative to large cap, across major markets. It’s certainly plausible that smaller companies have more of their debt as floating rate, meaning greater sensitivity to higher borrowing costs against the backdrop of the fastest interest rate hiking cycle for a generation. They may now face substantially higher interest rate bills, depressing profitability and dampening investor returns.
Say it ain’t so, can small caps grow?
The most obvious reason underpinning the relative performance is the enormous, but somewhat historically anomalous, growth rates by mega-cap technology companies. Particularly in US these companies are continuing to scale in a relatively asset-light manner compared to any point in mega cap history.
If small cap earnings are unable to keep pace, let alone grow at a faster rate, then investors are unlikely to take the added ‘risk’ within small cap. In addition, the deep pockets of mega caps mean they are able to acquire companies much earlier in their lifecycle to add additional growth to their own business. Eventually, the adoption of technology could become a double-edged sword. NVIDIA, for example, listed with a market cap of less than $2bn in 1999, today it is $2.3tn. It would be unreasonable to suggest this growth cannot occur again – who knows whether artificial intelligence becomes one of market’s great levellers and enables rapid growth in smaller companies harnessing its potential.
The effect is more widespread than the US, however. European small cap, for instance, now trades at close to its most meaningful discount relative to large cap peers, on a forward multiple basis, since pre-Global Financial Crisis.
Setting the stage for success
MSCI Europe Small Cap VS Large Cap 24m Forward P/E ratio
Source: Bloomberg, 30 April 2024
Watching, waiting, commiserating
Rather than a blanket approach to small cap risk and return, we prefer the edge fundamental equity managers still retain in this part of the market. The risks in small cap may be different – larger incumbents may be more agile than ever – but the same technology which is enabling this growth could well turbocharge their smaller equivalents, perhaps to an even greater extent.
If we are able to buy into multi-year relative low valuations, with skilled active small cap managers at the helm, all while private equity pay materially higher prices, then we’re comfortable being patient investors. Catalysts include either an easier monetary backdrop or even just a mild growth slowdown within mega caps. History suggests the snap back in small cap be rapid – Blink (182) and you’ll miss it.
