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Revisiting the investment case for small caps

Posted on February 18, 2013, Monday

IFAST-p1 IFAST-p2WHILE most equity portfolios should already have significant exposure to the larger-cap equity space, smaller capitalisation companies often escape the attention of investors, even though there are various benefits to be had by complementing larger cap equity exposure with smaller cap funds. In this article, we revisit some of the reasons why investors should not overlook small caps in their investments.

Stronger earnings growth

While earnings growth of the broader stock market is usually dependent on the pace of growth of the underlying economy, smaller or mid-sized companies may possess the ability to grow earnings at a much quicker pace.

Larger companies may find it more difficult to grow their revenues more quickly than the overall pace of economic growth, especially when they already hold a sizable market share in a particular industry. On the other hand, it is more plausible for a smaller company which has a negligible market share to grow its revenues by double digits each year, which could lead to a doubling or tripling of profits over a shorter period of time.

This trend is evident from a look at the historical earnings of global small caps versus the broader market, with small cap stocks delivering a 7.8 per cent annualised growth in earnings between 1999 to 2012, versus the more modest 5.2 per cent earnings growth for the broader market (see Chart 1).

Exposure to newly-minted sectors or industries

Following on the theme of growth for smaller cap companies, the segment also offer investors exposure to unique sectors or industries which have not yet “blossomed”, and thus do not feature within the larger capitalisation space of the equity market.

As an example, the growth of the internet in the late 1990s boosted demand for IT products and services, helping the Information Technology segment of the US market to grow from a paltry 5.9 per cent of the S&P 500 in 1993 to 18.4 per cent (as of February 13, 2013).

Today, in the large-cap S&P 500 index, companies like Qualcomm, eBay, EMC, Salesforce.com, Yahoo!, Dell and Adobe Systems are just some of the multi-billion dollar IT companies which started off as ‘small-cap’ public companies.

Greater potential for undervaluation

While proponents of the ‘efficient market hypothesis’ may beg to differ, smaller cap stocks can offer substantial scope for mispricing, since they generally garner less interest, particularly so from the likes of stock analysts.

As an example, companies within the Russell 2000 (a popular small cap US stock market index) had just 7.4 analysts covering each company on average (as of February 8, 2013 based on Bloomberg consensus data). In contrast, the large-cap S&P 500 stock index had 23.4 analysts covering each company on average, which indicates that there are approximately thrice the number of analysts scrutinising each large cap company versus each small cap company.

Higher possibility of being acquired

In addition to earnings growth and dividends, the expansion of the valuation multiple is a critical component of stock market returns. For investors in smaller companies, this valuation expansion can sometimes come a lot more quickly when a company is being acquired.

Companies acquire for a variety of reasons, which could include seeking new growth opportunities (by acquiring companies in new growth fields), for synergy (acquiring a complementary business which allows for a cost savings within the enlarged group), to defend market share (by acquiring a competitor) or for supply chain efficiency (acquiring companies up or down the value chain).

Acquisitions are thus usually undertaken by more mature companies (which are usually larger), while the process is also fairly taxing on corporate balance sheets (larger companies tend to have better access to financing), which usually results in larger companies acquiring smaller ones rather than the reverse.

Some risks, but numerous benefits

While we have highlighted some virtues of smaller capitalisation stocks vis-à-vis their larger cap peers, investors should remember that smaller companies can be more risky owing to a number of factors.

Nevertheless, there are clearly many positives which smaller-cap exposure can bring to one’s portfolio, especially if investments are sized in a prudent manner.

While the bulk of a portfolio should still consist of funds invested in larger-cap companies, investors may wish to consider adding some smaller-capitalisation exposure in the supplementary/satellite portion of their portfolios, or to carve out a portion from their regional market allocations to include some smaller company exposure.

At the time of writing, investors can choose from a selection of small/mid-cap focused funds invested globally, or in regions/countries like Asia ex-Japan, US, the Emerging Markets, Europe as well as Malaysia.

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