Understanding the risks

Exploring the diversification potential

Understanding the return premium and exploring the diversification potential

What are the higher risks that explain the small-cap premium? And what characteristics explain why smaller companies perform differently from their larger peers?

Risk and return are two sides of the same coin. Academic studies have tried to identify the higher risks involved in investing in smaller companies that help explain why investors should demand a higher return. Less talked about are the risks that are lower for smaller companies than large. Investors also need to understand the risks that are neither greater nor smaller but simply different. These provide a source of diversification. Finally, investors cannot ignore the risk factors that are common to all companies, large and small.

In general, the small-cap premium is explained as the reward for accepting the poor performance of smaller companies during periods of market stress. Active investors must decide if they are being adequately rewarded for this risk. Or they can decide to control these risks, for example by tilting portfolios towards higher quality companies.

Higher risk

1. Illiquidity risk

The shares of smaller companies are less liquid. They also have higher insider ownership, leaving a smaller free-float for external shareholders. This risk can be mitigated in a portfolio context. However, it translates into higher costs for entering and exiting positions.

2. Recession risk

Smaller companies have historically underperformed from the peak of an economic cycle to its trough. Looking at data for the US equity market since 1980, on average this underperformance was 5% during the five recessions that occurred over this period1. A longer view2 shows that the Great Depression (1929-1933) and the deep recession of the 1970s (1973-1975) were periods of significant pain for holders of smaller companies.

This analysis is based on perfect hindsight of when recessions began and ended. In practice, there is a long lag between the start of a recession and its identification. We associate recessions with bear markets. But here too hindsight is required to identify the start of a bear market. Nor do economic downturns and market downturns neatly coincide. This helps explain the somewhat counterintuitive findings of a Numis study3 the UK market: smaller companies outperformed in bear markets but underperformed in recoveries.

US small-cap relative performance and US recessions, 1926 - 2017

Chart1

Source: Professors Dimson, Marsh, Staunton and Evans, London Business School, CRSP, Morningstar, NBER

3. Credit risk

The cost of borrowing is higher for smaller companies4. (Indeed the cost of equity is higher too: lower average valuations for share buyers translate into higher cost for the companies issuing those shares.) This is consistent with the underperformance of smaller company shares when times are tough: during recessions. The small-cap premium is higher when rates are low than when they are high; and higher when interest rates are falling than when they are rising.

4. Inflation risk

Equity market valuations are higher when inflation is close to target and lower in periods when inflation is high, or when inflation falls close to zero or turns negative (deflation). This pattern is exaggerated for smaller companies, meaning the small-cap premium is higher when inflation is close to target but lower during periods of low or high inflation3.

5. Price volatility

The risks above translate into higher volatility of returns for an index of smaller companies than their larger peers.

Lower risk

6. Complexity

Big companies are complex organisations. Sony grew rapidly in the second half of the 20th century on the back of successful sales of Trinitron TVs and the Walkman. By the 1990s the company had become a bloated behemoth, employing 160,000 people5. With profits under pressure, the company divided into smaller units, asking each to focus on their own profitability. In 1999, one of these units launched the company’s first portable digital player at a computer industry trade fair in Las Vegas. Next on stage was a rival product from a competing Sony unit. Not surprisingly, consumers were confused and both failed. The complexity of large companies makes it harder for management to be in control.

7. Index concentration

The makeup of market indices reflects past success. Sometimes one theme dominates the market, leading to a concentration of stocks at the top of the list. Today, five US technology companies head the MSCI World Index: Apple, Microsoft, Alphabet (which owns Google), Amazon and Facebook; representing a combined 7.5% of the index6. This concentration increases in regional portfolios and is yet more pronounced in single country portfolios. For example, Samsung Electronics represents 28% of the MSCI Korea Index7. The overall performance of market-cap weighted equity portfolios can be skewed by the performance of a few large stocks.

Different risks

8. Currency exposure

Smaller companies have a higher proportion of domestic sales while larger companies include more multinationals. For example, domestic sales account for 63% of total sales for companies in the MSCI US Index compared to 78% of sales for companies in the MSCI US Smaller Companies Index8. This means small and large companies have different responses to currency moves.

9. Stock-specific risk

The performance of smaller companies is driven more by stock-specific risks, while larger companies are more sensitive than their smaller peers to other factors such as country, sector and style.

Stock-specific risk as percentage of total risk

Chart2

Source: Axioma

10. Different companies

A portfolio of smaller companies is a different set of companies to a portfolio of larger companies. While this might seem too banal to mention, investment in factor-driven (or smart beta) portfolios is growing and can lead to the same stocks appearing in more than one factor sub-portfolio. For example, 55 of the 151 companies in the iShares Edge MSCI USA Value Factor ETF are also included in the iShares Edge MSCI USA Size Factor ETF9.

11. Long-cycle performance

These different risks help explain why capturing the small-cap premium involves periods of outperformance and underperformance. The cycle between small-cap and large-cap leadership differs across countries. These cycles can last for a number of years.

Same risks

12. Traditional risk measures

Portfolio managers still need to take account of country, sector and industry exposures. They need to understand their exposure to style factors, such as quality, momentum and value. And, in particular, they need to be aware of the stock-specific risks that are best understood through fundamental analysis.

In conclusion, investors must understand the complex set of risks associated with smaller companies. But it is this understanding that provides the opportunity for active managers to deliver performance.

Sources
1 ‘The case for SMid’, E. Lecubarri et al, JPMorgan, 12 Sept 2017
2 Professors Dimson, Marsh, Staunton and Evans, London Business School, CRSP, Morningstar
3 Professors Scott Evans, Paul Marsh and Elroy Dimson, Numis Smaller Companies Index 2018 Annual Review
4 Aberdeen Standard Investment, Bloomberg
5 Gillian Tett, 2015. ‘The Silo Effect: why putting everything in its place isn't such a bright idea.’
6 MSCI World Index factsheet
7 MSCI Korea Index factsheet
8 Worldscope/FactSet
9 iShares

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