Making the case for small caps

Neal Doying
— 1 minute read

Small caps have delivered genuine risk-adjusted returns to investors, and there are still plenty of opportunities around, says Lazard Asset Management’s Neal Doying.

Neal Doying

Since the 1980s, a number of studies have shown that small-cap equities – those with market capitalisations from US$300 million to US$5 billion – have historically outperformed large-cap equities on a risk-adjusted basis.

What is the prevailing view for this phenomenon?  

Rolf Banz’s 1981 study was one of the first to highlight the small-cap performance phenomenon challenging the prevailing Capital Asset Pricing Model (CAPM), by which an asset’s return is explained by one variable: its systematic risk.

The academic consensus progressed toward introducing additional elements of risk to explain equity returns.

In their seminal paper, professors Fama and French concluded the outperformance of small caps over large caps was due to an element of risk unique to small caps – that is, investors are compensated for undertaking additional risk.

Recent JP Morgan research also noted the economic sensitivity of small caps.

The study showed that since 1990, the revenue growth rate of European small– and mid-cap stocks has been 2.2 times nominal GDP growth.

Small-cap outperformance may be particularly acute in periods when some or all of the following conditions occur: increasing credit availability, strengthening forward economic indicators, positive economic growth, rising earnings estimates, and ample M&A activity.

On the other hand, research shows small caps tend to underperform when those conditions are reversed.

Another potential reason for small caps’ superior risk-adjusted returns is that the lack of liquidity, added to a lack of readily available information, may deter some from investing in the asset class.

Companies that are only sought by a subset of investors tend to have higher risk-adjusted returns.

With less information available, many market participants may exclude small caps from their model portfolio opportunity sets because they may not be able to accurately assess the risks.

Globally, around 20 per cent of small-cap stocks do not have any sell-side coverage, which would be unthinkable in large or mega-cap equities.

The opportunity in small-cap companies significantly expands when global or international companies are considered.

International strategies oriented toward large-cap stocks outnumber those of small-cap stocks nearly tenfold.

If there are “dusty corners” in present-day equity markets, we can expect that some of the cobwebs may be aggregating in small caps.

Opportunities abound despite current prices

As of the third quarter of 2014 on a price-earnings basis, small-cap stocks appear to be more expensive than their large-cap peers in most markets.

However, given the faster earnings growth of small caps and their more cyclical nature, that valuation gap may be overstated.

After years of balance sheet repair, corporations have unprecedented amounts of liquidity in the form of cash on the balance sheet or low-interest debt available via banks or the public markets.

Corporate managers and boards may now have the confidence to spend some of their cash reserves or to take on debt as they struggle to advance earnings in a low-growth economy.

The cash on large-cap balance sheets alone represents about 40 per cent of the aggregate market cap of small caps globally (in Europe this number is about 72 per cent, and it is 56 per cent in the United States and Canada).

The current backdrop is conducive to large caps increasing activity on acquiring small caps.

At the same time, small caps have low levels of leverage, leaving ample room for more borrowing.

As such, I also anticipate a possibility for more acquisitions or consolidation within the asset class.

This adds another outlet for value to be realised, as an acquisition target generally receives a premium to the market price.

Lazard’s Global and International Small Cap Equity teams favour small-cap companies with strong returns on invested capital as we believe that companies that rate highly on this measure typically compound their advantages over time.

There is support for this idea in contemporary financial literature.

Popular investing books, such as The Little Book That Beats the Market, have supported the notion that firms with superior returns on capital outperform firms that fail to earn back their cost of capital.

Giving managers the freedom to deviate from benchmarks allows the portfolio to stay true to its mandate of searching the world for the best ideas.

Neal Doying is a US-based portfolio manager and analyst at Lazard Asset Management.





Making the case for small caps
Neal Doying
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