Small-cap companies outperformed their bigger cousins again in 2004, a trend that a joint ABN Amro and London Business School study released last month finds consistent with results over the past five years worldwide and over the past 50 years in the UK.
In 2004 the Hoare Govett Small Companies and HG 1000 indices, representing the bottom 10% and 2% of the UK equity market respectively, reached all-time highs and outperformed the FTSE All-Share Index by more than 7%. Over the past 50 years the two UK indices have outperformed the FTSE All-Share by 3.5% and 5.7%.
Over the 50 years between 1955 and 2004, the smallest 10% of companies in the UK provided the highest annualized return, 31.6%, and successive deciles had consistently lower performance, with the largest achieving an annualized return of 13.9%.
A sum of £1,000 invested in the HGSC Index in 1955 would today be worth £1.8 million, with dividends reinvested, compared with just £400,000 for the FTSE All-Share. The same sum invested in the HG 1000 would now be worth £4.6 million.
Small companies outperformed large ones by three percentage points in the UK over the five years between 2000 and 2004. This pattern was repeated in 20 of the 22 leading markets worldwide over the past five years, with only Norway and Austria bucking the trend. On average, small caps outperformed large ones by four points worldwide.
Recent small-cap outperformance can be largely attributed to sector weightings. Major indices are dominated by just a few sectors such as banks, oil, pharmaceuticals and telecoms, which account for over 50% of the FTSE All-Share, for example. When these perform well, indices benefit proportionately.
One explanation for the outperformance of small caps could be that they need to offer a premium to compensate investors for higher trading costs, a result of poor liquidity.
Another is neglect. Because small caps are less well covered by investors, spotting opportunities and undervalued companies is easier than for large caps, where an information advantage is much harder to achieve.
No-one can fully explain why small caps have done so well. ?There are lots of theories put forward to explain why, over the long run, small companies seem to outperform,? explains professor Paul Marsh of the London Business School, one of the report’s authors, ?but none other than liquidity and neglect seem to hold up in the long run and they would suggest a much smaller premium than what we observe.?
