According to the Hoare Govett Small companies index report, an annual review of small-cap performance compiled by ABN Amro and the London Business School, small companies outperformed large ones in 15 out of the 22 countries studied in 2006. In only three countries, Portugal, Japan and Ireland, was their performance significantly worse.
Such superior performance has won small companies some big fans, such as hedge funds, but there are growing signs that the attention lavished on them might be making them less interesting.
According to a recent study by Citi about 8% of all European small caps have hedge fund ownership of at least 10%, while only 1% of large caps are at least 10% owned by hedge funds.
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Small is bountiful |
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Annualized small-cap premia over large caps for 22 countries and the World Index |
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Source: Hoare Govett |
Investing in small-cap and mid-cap companies is a natural strength of the value-investing breed of hedge funds that have real expertise in stock-picking.
"The dispersion between the best-performing and worst-performing small and mid-cap stocks is huge," says Thierry Olive, head of equity capital markets at BNP Paribas in Paris, "so the key to successful investing in them is stock-picking. Hedge funds investing in smaller companies coming to the market devote substantial time and energy to understanding the companies and their value drivers to sort the winners from the losers. Any fund looking for growth has to look at smaller or mid-cap firms as these are the ones that offer something different."
Stock-picking among small and mid caps also tends to be a neater affair because smaller companies typically have businesses that are more easily understood.
"It is easier for an investor to look at a small-cap company carefully and to understand its business drivers than to do the same at a large global company where there tend to be many other factors," says Nick Nelson, European strategist at UBS in London. "Small-cap performance depends more on the company’s product, keeping costs under control, and management performance, whereas at a multinational there can be so many products and markets that can influence performance."
Investor interest in small and mid-cap companies has become so great that these companies are now trading at a premium to large-cap stocks, a phenomenon that has only occurred in four out of the past 15 years.
Large caps are normally expected to trade at a premium to small caps because they are generally better-established companies with more diversified and less volatile earnings and because their stocks trade with better liquidity.
European large caps, however, are now trading at a 16% discount to small caps, according to UBS.
Some analysts speculate that the growth of long/short investing might also be a significant factor in this phenomenon. If a fund has to be long one part of the market and short another, they argue, it is much more likely to go short larger, more liquid stocks for which it is easy to borrow stock than less liquid ones where it can be extremely difficult or impossible. This argument has caused some analysts to theorize that the imbalance in stock-lending possibilities between large-cap stocks and smaller ones has created a new equilibrium in which large-cap stocks will tend to trade at a discount to smaller ones.
Other analysts, however, believe that the pendulum might have swung too far for now and that large caps are now likely to outperform smaller stocks.
"Bid speculation has been a strong supportive factor for small caps but deal sizes are getting larger and larger so there is a lot of potential for corporate activity among large-cap companies," says Nelson at UBS. "Large-cap stocks are now not only cheaper than small caps but they are also less geared, so those that don’t get involved in M&A still have plenty of room to regear themselves."
Investors that have been turning to international small caps for diversification could also soon be regretting it, despite the fact that correlations have actually fallen.
| Small but growing |
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Source: Hoare Govett Smaller Companies Index 2007 |
According to analysis from ING Investment Management, the monthly correlation between international small caps and the S&P 500 has decreased substantially. For the five years between February 2001 and February 2006 the monthly correlation was 0.28. Between March 2006 and March 2007, however, the correlation was just 0.08.
The fall in correlation, however, was largely due to the poor performance of small caps in Japan, where small caps underperformed large caps.
More important, although smaller companies might provide diversification and superior performance in a bull market they tend to be hardest hit in bear markets because of their less diversified earnings and higher gearing.
"The saying is that when stocks go up they go up one by one but when they go down they all go down together," says Brian Gendreau, an investment strategist at ING Investment Management in New York. "It’s a cliché but it’s true. There is a higher probability of a higher correlation in down markets. When the markets went down in May last year and in February and March this year, small caps were the worst hit."
In the US there are signs that the tide might have started to turn against small caps as fears about slowing corporate profit growth set in. According to Citi, short positions in companies in the Russell 2000 Index, a small-cap benchmark index, jumped in March to their highest since at least September 2003. The percentage of shares sold short in the Russell 2000 was more than five times greater than in the S&P 500.