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Small Caps: Time to Invest?


  • Small caps have lagged the S&P 500 in the last two years, but historically outperform it.
  • Stock pickers could find a gem in the small cap world but risks are also big.
  • Small caps are more related to the US economy than large caps.

What Are Small Caps?

Small caps are stocks with a relatively small market capitalization, usually between $300 million and $2 billion. One of the multitude of reasons behind investing in small caps is their growth potential, as it is generally considered that smaller companies have more growth opportunities due to untapped markets. Another reason for investing in small caps is the fact that big investment funds might overlook some smaller profitable investments due to their lack of liquidity or low free float. Thus, an astute investor can make large profits by buying the next large cap at low prices, before the big guys buy in and raise the price. As small caps are mostly local companies, or constrained to one country, they should not be affected by macroeconomic influences like slower Chinese growth or the strong dollar. A technical reason to invest in small caps is that they have underperformed the market in the last 5 years and now might be a good time to change the weighting of a portfolio from blue chips to small caps.

Historical Performance

The most popular index for tracking small cap returns is the Russel 2000 Index which comprises 2,000 small cap companies from the US. The Russel 2000 has returned 33.6% in the last 5 years and underperformed the S&P 500 which returned 52%.

1 figure 1 SandP 500 russel 2000

Figure 1: Russel 2000 and S&P 500 5-year performance. Source: Bloomberg.

The underperformance was probably caused by increased turmoil in junk bond markets and financing difficulties while big companies continue to enjoy low interest rates.

But, underperformance could indicate an opposite effect in the future as both indices are well diversified and their performance should reflect the US economy. Also, analysts expect the Russel 2000 earnings to grow by 9.6% in 2016 and S&P 500 earnings to be flattish. From a fundamental perspective the PE ratio is on the S&P 500 side at 24.12 while the Russel 2000 has an incredible 401.25. Although, 2016 estimates are on Russel’s side, with 17.52 versus the S&P 500’s 17.65. The high current Russel 2000 PE ratio is probably related to the fact that many small US companies are in the US shale oil sector which has been battered in 2015 and continues to fall as many companies file for bankruptcy.

Risks of Investing in Small Caps

Small companies tend to be more uncertain than their bigger counterparts. There is no loyal customer base, operational history and every project immediately looks riskier. It is always easier for the big fish in the pond to weather storms, correct mistakes or grasp opportunities. Ownership is more concentrated and there is a lower trading volume and free float. A low free float makes a stock vulnerable to short attacks.

Small caps have limited access to capital and the current increases in interest rates create more future uncertainty. Limited access to capital makes small caps reluctant to pay dividends as available capital is steered towards growth investments. Information is also scarce, analysts may have limited access to financial statements prior to an IPO and future forecasts are based on less reliable information.

2 figure coverage

Figure 2: Number of analysts and coverage. Source: New York University.

But, the low coverage percentage and limited number of analysts creates opportunities.

Advantages of Investing  

Low coverage might enable a stock picking investor to discover a gem and create returns that cover for all the risks. A small starting base makes growth easier and especially in a quickly evolving digital world, small caps have the ability to change strategy faster than large caps. Aside from stock picking, a small cap index fund can also bring good returns. Historically the longer the investing period the higher the small cap returns and the certainty of over performance are.

3 large small cap

Figure 3: Time horizon and small firm premium. Source: New York University.

The average return for small caps from 1930 to 2013 was 12.7% while the S&P 500 index returned 9.7% and as the above research shows in any period longer than 20 years small caps have always outperformed the S&P 500 index.

US or International Small Caps

The small cap over performance holds its grounds also on a global level. Only in Norway, Denmark and Italy did small caps not earn a premium in relation to large caps in the long term.

4 global prem

Figure 4: Annual premium earned by small cap over large cap stocks. Source: New York University.

Investing Opportunities

The first investing strategy is to look for small caps that give quality diversification to a portfolio and allow it to hit the jack pot. This requires lots of an investor’s own due diligence as most of the small caps are poorly followed by analysts and they involve high risk.

The second potential investing strategy is to invest in small caps through index funds or ETFs. Besides the Russel 2000, the second most popular small cap index is the S&P Small Cap 600 index. As it does not include all small caps, it provides better sector diversification.

5 figure sector sap 600

Figure 5: S&P 600 sector breakdown. Source: S&P Dow Jones Indices.

A fund tracking the S&P 600 index is the Vanguard S&P Small-Cap 600 Index. For global ETF small cap diversification, opportunities include the SPDR S&P International Small Cap ETF that invests only in non US developed countries. The Vanguard FTSE All-World Ex US Small Cap ETF (VSS) provides a mix of developed and emerging small caps, and there are also much riskier emerging countries ETFs like the Market Vectors Brazil Small Cap ETF (BRF).

Conclusion

Investing in small caps can bring increased returns but it also increases risks as the volatility is much higher than for large caps. In any case, small caps should be a part of a well-diversified portfolio. Increased diversification can be achieved by going global.

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