Small(er) stocks hit it big

Be it Apple in the USA or Nestlé in Switzerland, it’s the big names that mainly stand in the foreground on equity markets. But smaller companies don’t have to hide in the background as wallflowers. Quite the contrary, in fact, historically they have mostly delivered significantly better risk-adjusted returns than their larger-cap counterparts. Active investment in smaller stocks looks destined to continue to pay off and generate alpha in the future.


Small but mighty

Big names generally predominate on investors’ stock lists and in the financial news because it’s companies like Apple in the USA and Nestlé in Switzerland that determine the direction of the best-known equity market indices. The US-based technology behemoth briefly reached a stock market value of USD 3 trillion at the start of this year. At last look, Apple alone accounted for around 7% of the market capitalization of the USA’s blue-chip S&P 500 index. But it pays for investors to think outside the box and not to choose their picks solely from the same old cast of large-cap companies. Because in the second tier and especially the third tier, there are a vast number of interesting companies that have only a fraction of the weight of large caps, but which often tip the scales with greater innovation and growth. Small-cap enterprises in particular, which (depending on the definition) are companies with a market capitalization of USD 5 billion or less, are in many cases (world) market leaders in a wide array of different industries and niches operating under names that are less well-known to the public.


Continuous outperformance…
Small beats big in all markets

Annualized performance since 2002

Sources: Bloomberg, JPMorgan, Kaiser Partner Privatbank


Small caps, at any rate, performed impressively over the last two to three decades, outpacing large caps in almost every region of the world. They even outperformed large caps in all of the arguably most important single markets for Western investors (USA, Eurozone, Switzerland, UK) during that period. While their annualized outperformance in the particularly competitive US market amounted to a respectable 2.0 percentage points, in Europe small caps beat large caps even more significantly by an annualized 3.2 percentage points in Switzerland and by even 6.7 percentage points in the Eurozone. Over a long time horizon of a decade or more, such inconspicuous annual return differentials can tally up to considerable added value for investors.


…adds up
Small caps well in the lead over the longer term

Performance since 2002

Sources: Bloomberg, JPMorgan, Kaiser Partner Privatbank


More than just beta

It is a myth, however, that this superior performance by small caps only comes in exchange for higher risk. Even during recessions, the toughest times imaginable for equity markets, small caps are not clear underperformers, contrary to what one might presume. The evidence over the last 30 years is mixed on this count – small caps have sometimes performed better and sometimes worse than large caps during recession phases. The long-term beta for small caps (excluding those in the USA) is actually well below 1, which means that smaller stocks are less sensitive to movements in the broad market than large caps are. A look at the volatility of small caps over the last 20 years reveals that it is only marginally higher than large-cap volatility in most markets and even substantially lower in Switzerland. Higher returns amid similar or lower volatility mean better risk-adjusted returns (Sharpe ratios) – far superior in some cases – for small caps. So, it makes wise sense also from a risk perspective to blend smaller-cap stocks into a diversified portfolio.


Not just a beta bet
Small caps also deliver a better risk-adjusted return

Annualized Sharpe ratio since 2002

Sources: Bloomberg, JPMorgan, Kaiser Partner Privatbank


Structural tailwind

But what explains the excess return on small caps? There, in fact, are an array of structural reasons that help to explain small caps’ alpha. For instance, small-cap companies’ revenue and earnings generally grow faster than the sales and profits of large caps, in part because small caps are often younger enterprises that are still in an early growth stage. Large established companies, in contrast, often operate in markets that are almost saturated. Anyway, the growth differential between small- and large-cap companies in industrialized nations since 1990 amounts to 2 percentage points. Moreover, small enterprises are often attractive takeover targets. Around 95% of all M&A deals worldwide each year involve the purchase of a small-cap company (with an enterprise value of less than USD 5 billion), and the buyer usually pays a sizeable takeover premium, which has stood at an average of around 30% lately. This contributes significantly to smaller stocks’ outperformance over the long run. Last but not least, the circle of shareholders in small caps often includes insiders and stakeholders that have a lot of skin in the game and thus have a greater (financial) interest in receiving high, sustainable returns on investment.


3, 2, 1 – mine
Smaller companies are attractive takeover targets

Global M&A activity (number of deals)

Sources: Bloomberg, JPMorgan, Kaiser Partner Privatbank


Alpha also in the future

But that’s not all. Part of the alpha of small caps is also explained by the fact that small, less well-known companies are usually barely present on or entirely absent from the radar screens of investors and analysts. Whereas large caps in the USA and Europe each receive research coverage from an average of 17 brokerage houses, there are only three or four company analysis and investment recommendation publishers per small cap. Around a quarter of all small-cap companies in the USA and Europe are not covered even by a single analyst. This research gap is precisely what opens leeway for alpha. Whoever puts time and energy into analyzing smaller companies that are practically not watched by anyone can gain an information advantage over the mass of investors and can potentially convert it into a performance advantage. Even in the digitalization age shaped by extensive networking and rapid data transmission, in which we ordinarily deal with largely efficient markets, this “inefficiency” in the small caps sector continues to exist to this day. There’s little suggesting that this won’t continue to create opportunities in the future. It therefore will likely remain worthwhile in the future to rely on active management in the small-cap universe instead of simply buying an ETF.


Barely on the radar
Small caps are analyzed less

Research coverage of small caps (number of brokerages) in the USA and Europe

Sources: Bloomberg, JPMorgan, Kaiser Partner Privatbank


There’s a compelling case to be made for small caps (and plenty of arguments suggestive of an edge over large caps) even in the face of challenging geopolitical developments. Small-cap companies, for example, earn a comparatively larger share of their revenue in or near their respective home countries and thus are somewhat less exposed to protectionist tendencies and shocks to global trade. Exceptions confirm the rule. And smaller companies are at least unlikely to necessarily be at a disadvantage in the current macroeconomic climate marked by spiraling inflation and potentially lower future growth. Since small caps (especially those in the manufacturing and consumer goods sectors) are often market leaders in their specific niches, they usually wield a certain degree of pricing power. So, most of them should be able to pass higher prices onto their customers and to defend their profit margins. Whoever expects to see weaker economic growth going forward can likewise take a constructive view on the small caps segment. A look at Japan and the evolution there over the last 20 years – a period shaped by unquestionably anemic growth and a number of different crises – inspires confidence in any case: Japanese small caps outperformed the large caps in the Topix 100 index by a wide margin over that period.


Historical digression
Solid performance even in the Japanese scenario

Stocks and interest rates in Japan since 1998

Sources: Bloomberg, JPMorgan, Kaiser Partner Privatbank


Our expertise on small caps

Whoever would like to capitalize on the “alpha opportunity” that small caps offer has to keep his or her ears close to the market and must invest actively. Kaiser Partner Privatbank has built up extensive expertise on the Swiss small and mid-caps market in recent years. Our Swiss Stocks Basket invests in a diversified portfolio of companies, with a focus on quality stocks with attractive growth prospects. It concentrates on companies that have a competitive edge, a leading position in the market and an attractive market structure. Since the inception of the strategy at the start of 2016, we have earned a return of +149.8% with our approach and have handily beaten the benchmark Swiss Performance Index (+88.6%). Our Swiss Stocks Basket has delivered an annualized return of +15.8% p.a. over that period while the overall market has returned +9.9% p.a., and the excess return was achieved with comparable risk (volatility: 11.7% for the strategy vs. 11.4% for the benchmark). We are confident that our carefully assembled basket of Swiss stocks will continue to deliver alpha for our clients in the years ahead.


Oliver Hackel, CFA Senior Investment Strategist

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