The case for small caps in a world of deflation and disruption

2 May 2016

The recent underperformance of a number of small cap markets has prompted suggestions that the traditional arguments in their favour no longer hold. We disagree. As we enter a period of unprecedented disruption and deflationary growth, we argue that small caps can bring a number of unique characteristics to a wider portfolio.

Over the last 30 years, the case for investing in small caps has been debated extensively1. The long-term statistics certainly suggest that smaller companies do indeed outperform larger ones (Figure 1). There is less agreement on the reasons. The explanations range from the contention that small caps offer a risk premium in return for lower liquidity, that limited research means any new information has a bigger impact on the shares, and/or that small companies in aggregate tend to grow faster than larger ones. Whatever the case, even though US small caps have underperformed large by over 10% in the last two years2, their outperformance over a longer period is dramatic. So what of the future?

Figure 1: Small caps leave larger companies far behind over the long term


Rebased to 100. Source: Left chart: before March 2006, Ibbotson; after March 2006, S&P LargeMidCap and S&P SmallCap, all in dollars. Right chart: Lipper, in sterling. Both to 31 December 2015.

In truth, the outlook for all investors is murky. Everything from disruptive technology to persistent low growth is making it easier to pick losers than winners. The challenges span the waterfront, from environmental concerns that put a question mark over the future of the carbon-based economy, to advances in artificial intelligence that could undermine the position of over 230 million knowledge workers around the world3.

In these circumstances, and contrary to received wisdom, we think more winners may be found amongst the mass of lesser-known and under-researched smaller companies than amongst their larger brethren. With innovation and technological advances moving at an unprecedented pace, companies that are nimble and less burdened by layers of management may be better equipped to keep up with these changes. In this environment, having a strong brand, a large installed base and a wide distribution network are not necessarily assets anymore. Instead we are seeing a new generation of winners that are “capital light” and have a strong online presence. As industries evolve in this direction, barriers to entry are reduced and innovations progress faster, creating increasing opportunities for small companies.

1 Eugene Fama and Kenneth French, Common Risk Factors in the Returns on Stocks and Bonds, Journal of Financial Economics, vol 33 1993. Elroy Dimson and Paul Marsh, Investment Analyst, January 1989, vol 91.
2 S&P 600 returned 3.67%, S&P 500 returned 15.26%, 31.12. 2013 – 31.12.2015. Source: Datastream.
3 Disruptive technologies: Advances that will transform life, business, and the global economy, McKinsey Global Institute, 2013.

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