Is the Small Cap Premium Dead?

If not, it’s certainly fast asleep.

Most academics and practitioners agree the small cap effect is real – that is, investing in smaller companies produces higher returns in the long run. This effect has been measured in most developed country stock markets, and it’s been around for at least a century. However, in recent times this finding has been questioned. For example, Gary Antonacci blogged recently that the small cap effect was based on measurement error, among other things. I could quibble with his numbers, but others have reached similar conclusions, and their arguments were compelling enough for Cliff Asness to write his paper: “Size Matters, If You Control Your Junk”. Asness’ main argument: small size still improves returns if you remove stocks with poor earnings and high debt. More broadly, investing in small stocks is a good idea if you are aware of the risks and take steps to control them.

In Australia, the under-performance of small cap stocks is much more dramatic. And this is alarming for small cap investors such as myself. But first, below are a couple charts of the commodities bull market up till 2007. During this period, small caps returned 245% compared to only 195% for large caps. This is how things are supposed to be. Smaller stocks carry higher risk, and should therefore have higher returns. And usually it works that way.

After the GFC, things seemed to be getting back to normal. Small outperformed large again up until Febrary 2011, and then stopped. Weaker commodity prices, risk aversion and a slowing economy put small caps into a funk. The two charts below tell the sorry tale. First, small stocks which have returned -3% since 8 April 2011:

 

Compared to large caps which have returned 48% over the past 6 years, a performance gap over small of 51%!

In 2016, for a while I thought things were getting back to normal. Up until August 2016, small cap miners surged because of a bump in gold, coal and iron prices. But then, while large caps drove the market higher, small caps fell back. The past 6 months has seen small caps fall steadily, while the rest of the market has surged in response to Trump’s coronation.

I guess the million dollar question is whether smalls will start to shine again. My gut says yes. Most things in the markets are cyclical. Investing styles go in and out of fashion. But under-performance is acutely painful whenever it occurs, even if you know it’s temporary. And this makes it incredibly hard to stick to a plan that you know will work best over the longer term. At the moment, trying to eke a profit out of small caps feels like wading through mud.

It’s also worth considering whether a 6-year slump is a sign that things have changed for good. Some possible reasons might include:

  1. The rise of passive investing, such as Vanguard index funds, which channels money into large stocks at the expense of small stocks.
  2. Risk aversion, part 1. Baby boomers retiring and wanting to put all their money into larger, safer investments.
  3. Risk aversion, part 2. A more regulated, less dynamic Western society.  Tyler Cowen has written a great book called The Complacent Class which investigates the shift in the West from a dynamic, creative culture to one that is more concerned with holding on to what we have. (video here). This is related to the point above. Basically, not enough young people with ambition and an appetite for risk.
  4. Risk aversion, part 3. Banks are unwilling to lend to smaller, riskier businesses since the GFC. In the US this has also resulted in the “death of the IPO”.

I suspect that all of the above are cyclical, not permanent features of the investment landscape. But time will tell.

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