Benefits of Small Caps in an Equity Portfolio

Small cap stocks do not exist in a vacuum. To bring value to an investor’s portfolio an allocation to small companies needs first and foremost to deliver returns. Returns above the small cap index are a useful place to start, however the real test is for small caps to deliver meaningful returns above what can already be achieved through an investment in the S&P / ASX 300 Index of predominantly large cap stocks. Small caps can pass this test, with the caveat of needing to be active.

The second benefit small caps bring to a portfolio is diversification. This diversification comes from fundamental structural differences between small and large cap stocks and although most of these are positive, there are some structural headwinds investors need to be aware of to capture the available higher returns.

Small caps provide diversification in four primary ways, three good and one bad;

• Sector diversification (good): Small caps have different sector weights driven by the fundamental scale differences in sectors and industries. Banking, insurance, utilities, infrastructure, and supermarkets are all examples where scale is a driver of competitive advantage and representation in large caps is structurally higher. Other sectors like specialty retail, information technology and healthcare can have advantages in being small. Due to structural drivers, we believe these sector differences will persist.
• Firm age (mostly good): Small caps have greater representation of younger firms in an earlier stage of their corporate lifecycle, which provides a different sort of diversification. This can show up in various firm attributes such as higher growth, access to emerging industries, higher insider shareholding, corporate focus, greater management influence, limited sources of financing. Some of the risks that come with young age can be mitigated through portfolio diversification and a quality focus.
• Breadth and turnover of opportunity (good): The small cap market has three to five times more companies entering (IPO, spin out, promotion from microcaps, demotion from large caps) and exiting (takeover, promotion to large cap, corporate failure) than large caps which results in greater and more dynamic breadth of opportunity over time. This requires a process able to evaluate a large and changing investment universe.
• Quality (bad): Small caps have a much higher representation of low-quality businesses which results in a high negative beta to quality that can overwhelm the other three benefits and result in investment underperformance. This is structural, is observed globally and is the reason we believe the Australian small cap index doesn’t make a compelling case for passive investment in small caps. This is the primary negative attribute of small caps which we believe can be successfully rectified through active management.

More than 25 years of empirical evidence supports our belief that to benefit from the performance and diversification of a small cap allocation, investors need an active rather than passive approach. Investor opinions differ why this is the case, but our belief is that high index exposure to low quality companies is a major culprit. Our solution is to actively invest in a diversified portfolio of high-quality small companies.

The Importance of Quality

Our experience investing in small caps over many years has shaped our view that quality is a key driver of delivering long term outperformance of small cap portfolios. Outperformance both against the small cap index, but also against the large cap alternative.

Recent research (Size matters, if you control your junk, Clifford Asness, Andrea Frazzini, Et Al, Journal of Financial Economics, June 2016) analyses why this is the case. Globally, the benefit from passively investing in small caps appears tenuous at best – echoing what Australian investors observe when they look at the S&P / ASX Small Ords Index total return against the S&P / ASX 300 Index total return over long periods (hint: it is lower and more volatile with bigger drawdowns).

The key finding from the Asness, Frazzini research was that the distribution of quality companies differs greatly between small and large cap universes. Consistently, across time and across markets, small caps have a much larger representation of low-quality businesses than large caps. It is this weight of low quality (or junk using their term) that results in a negative beta to quality and an underperformance (or lack of consistent outperformance) from passive small cap indices.

By actively reducing the exposure to these junk companies, the researchers found a significant, consistent and global improvement in the performance of small caps relative to large caps.

The importance of quality in small caps is so great, that contrary to common wisdom it appears quality is more important than either value or growth in delivering superior investment returns from this part of the market.