Username
Password
Forget Password?
  1. Indices
  2. Commodities
  3. Currencies
Straits Times 3,114.16 -11.98 -0.38%
Hang Seng 26,719.58 -128.91 -0.48%
Dow Jones 26,770.20 -255.68 -0.95%
Shanghai Composite 2,938.14 -39.19 -1.32%
Revisiting The Investment Case For Small Caps
Malaysia Perspective | 20 March 2013
By:

By Yeo Mei Kei

2012 was a surprisingly good year for equity funds, particularly so for selected funds invested in the smaller capitalisation space like the Hwang Asia Quantum Fund which rose a hefty 27.4% (which was better than the 15.1% return for the broader Asia ex-Japan market) or the OSK-UOB Emerging Opportunity Unit Trust which posted a 22.6% return in 2012, significantly outpacing the 10.3% return for the broader Malaysian equity market.

While 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% annualised growth in earnings between 1999-2012, versus the more modest 5.2% earnings growth for the broader market (refer to Chart 1).

Chart 1: Earnings Growth

As earnings of the underlying companies will eventually drive the stock market performance over the long-term, smaller cap stocks have indeed delivered a superior return vis-à-vis the broader market (refer to Chart 2), with a 7.7% annualised return (in USD, including dividends), while the broader market delivered a lower return of just 1.8% over the same period.

Chart 2: Superior Small Cap Performance

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% of the S&P 500 in 1993 to 18.4% today (as of 28 February 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. 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.

In addition, 129 companies (6.5% of the index) within the Russell 2000 had just one analyst covering the company (2 companies had no analyst coverage), suggesting a stronger potential for stock mispricing within the small cap space. Less investor or analyst scrutiny could result in information asymmetry and a higher probability of stock mispricing, offering the opportunity for managers to deliver outsized gains in the small cap space.

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. Needless to say, smaller companies (particularly undervalued ones) have a higher chance of being acquired by a larger company, as illustrated by Bloomberg-compiled data on global mergers and acquisitions: of the 2494 publicly-listed companies which were the target of an acquisition over the past 12 months (as of 28 February 2013), just 3.1% of the deal sizes were over USD2.5 billion, suggesting that a majority of acquisition targets were companies in the small- to mid-cap space.

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. Since these companies can sometimes be involved in new industries which have not yet matured, there is heightened business risk, with the company being crowded out by various other competitors or subjected to a price war with a larger competitor. Access to financing is also generally more difficult for smaller companies, with financiers preferring business stability over growth prospects, which could result in a premature bankruptcy of smaller companies, especially when market conditions deteriorate. Stocks of smaller companies can also be more volatile compared to their larger-cap peers, given that small cap stocks are often less liquid, resulting in larger price fluctuations – between 1999 and 2012, global smaller companies demonstrated an annualised volatility of 19.5%, higher than the broader market’s 16.6%.

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.

Yeoh Mei Kei is a Senior Research Analyst at Fundsupermart.com.

Join The Conversation
The Shares Investment editorial team welcomes constructive feedback on our coverage and content. We would also be delighted to answer any questions on the above article. Leave us a comment below, and we'll get back to you shortly!

All Rights Reserved. Pioneers & Leaders (Publishers) Pte Ltd. Best viewed with Mozilla Firefox 3.5 and above.