The Investment Opportunity

Above-market returns from a broad and deep investment universe

Why should investors consider allocating money to smaller companies? Why should they expect a higher return? And what are the risks involved?

The Center for Research in Securities Prices at the University of Chicago Booth School of Business provides the longest history of size-ranked stock indices. A dollar invested in US larger companies in 1926, with dividends reinvested, grew in value to $5,767 by the end of 2017. A similar investment in small-caps grew to $38,842, over six times moreSee Chart 1.

Chart1

Smaller companies raced ahead between 1975 and 1983, attracting the attention of academics and investors. Between 1984 and 1997, the ‘small-cap premium’ turned negative, leading investors to question the higher return produced by investing in smaller companies over large. Instead this difference was rebranded the ‘small-cap effect’, reflecting that smaller companies performed differently to large, sometimes lagging and sometimes leading. The recovery from those lows has attracted less attention, but the universe of smaller companies is too big to be ignored.

Small companies – big investment universe

Smaller companies account for 14% of the MSCI All Country (AC) World IMI Index2 see Chart 2. This index captures 99% of the global equity investment opportunity set across 23 developed markets and 24 emerging markets, including large and small-cap stocks. This means that smaller companies represent a greater proportion of the world index than any single country outside of the US. They also represent a higher weight than the combined emerging markets.

They are also large in number. The MSCI AC World Small Cap index has 6,154 constituents in comparison to the MSCI AC World index (of large and mid-cap stocks) which has 2,499 see Chart 3.

Chart2

Source: MSCI

Chart3

Source: MSCI

Smaller companies premium – a global perspective

Rolf Banz, a PhD student at the University of Chicago, first identified the small-cap premium in US stocks and published his findings in 19813. This triggered similar studies around the world. In a 2018 study, Professors Dimson, Marsh and Evans from the London Business School provide a global perspective4. They calculated the small-cap premium to be 5% per annum for the 21 largest countries in the FTSE World Index between 2000 and 2017. Smaller companies outperformed in 19 of the 21 countries see Chart 4.

Global smaller companies premiums from 2000 to 2017

Chart4

Source: Professors Scott Evans, Paul Marsh and Elroy Dimson, Numis Smaller Companies Index 2018 Annual Review

Smaller companies effect – understanding the risks

The fundamental explanation for the small-cap premium is that the stocks of smaller companies are higher risk. Returns are higher but so too is the volatility of returns. There is no ‘free lunch’ available simply by buying a smaller companies index. Instead, successful investing requires a deep understanding of these risks and the potential rewards that they offer.

Sources
1 Professors Dimson, Marsh, Staunton and Evans, London Business School, CRSP, Morningstar

2 MSCI All Country (AC) World IMI Index Factsheet

3 The Relationship between return and market value of common stocks, Rolf Banz, Journal of Financial Economics, 1980

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