The case for small caps in a world of deflation and disruption
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 extensively 1. The long-term statistics certainly suggest that smaller companies do indeed outperform larger ones (Figure 1 below). 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 years 2, their outperformance over a longer period is dramatic. So what of the future?
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 underresearched 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 withthese 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 entryare reduced and innovations progress faster, creating increasing opportunities for small companies.
However, periods of disruptive innovation inevitably create losers as well as winners. One classic period was the dotcom bubble. During most of this time, the US small cap index underperformed the large cap index (Figure 2, below). However, a very different story emerges when we break the small cap universe down into sectors. Smaller pharmaceutical, biotechnology and software companies outperformed the US S&P 500 index of larger companies, whereas traditional industries, such as banking and retailing, lagged behind (Figure 2, below right). This shows how vital it is to be able to actively pick winners when disruption occurs.
What often handicaps traditional companies when it comes to developing or adopting a disruptive innovation is the fear of cannibalising their existing revenues. In contrast, smaller and newer companies not tied to an established product have more incentive to direct resources to the next disruptive innovation. Medical technology is a good example of this. Historically, incumbent providers of medical equipment, such as video scopes for internal examinations, focused on reusable technology that is high margin, but also expensive. Clearly, these incumbents had little incentive to produce a lower cost alternative as such a course would have eaten into demand for their existing products. This allowed Ambu, a small cap technology company with fewer existing sales to defend, to launch a single-use alternative which was both cheaper and came with a lower risk of infection. Not surprisingly, this has allowed Ambu to disrupt the existing market and gain market share.
There are, of course, a number of examples of large technology suppliers operating in markets where the “winner takes all”. Here the so-called FANG (Facebook, Amazon, Netflix and Google) companies with dominant technology often use their substantial cash reserves to buy up smaller competitors. For investors in the shares of these publiclytraded small companies, this is clearly good news, even if it may limit their opportunities for making even larger gains.
Of course, not all small technology companies are publicly quoted. With return prospects low, venture capital financing is popular and often more readily available than other sources of finance (Figure 3, below). In this environment, innovative companies may remain private long after the development stage, denying investors the chance to piggy-back on rapid growth. For example, the electric car manufacturer Tesla floated when it was valued at over $ 2 billion, while the appbased taxi group Uber remains private and is already worth over $ 50 billion. However, we would argue that the publicly listed universe of companies still provides ample opportunity to find disrupters. For example, at the end of February, the technology sector accounted for 3.8% of the FTSE SmallCap index, more than twice the figure for either the FTSE All-Share or the FTSE 100 indices. In the tech-heavy NASDAQ index in the US, about 65% of the constituents by number are valued at $ 500 million or less4.
Beyond these general characteristics, we would identify a number of specific areas where smaller companies enjoy advantages not necessarily shared by their larger rivals:
Success can come by moving into a gap in the market that others may be too large to occupy profitably. Xing, a German-based professional network platform provider, is an example. It has grown by running a career-based network exclusively for German speakers, an area that may have been of less interest to larger players. Similarly, specialist Japanese restaurant booking system Kakaku.com now dominates the market in Japan, while competitors such as OpenTable have aimed for the global market.
The rapidly growing market for safety products is another niche that offers fertile ground for smaller companies. For instance, the industrial protective clothing market is expected to grow at 11.5% per year until 20225, boosting protective clothing suppliers such as Ansell. This is an example of a smaller company that has been around for a while, yet remains well placed to capitalise on changes in the market around it. Ansell shows that companies don’t need to be constantly innovating in order to grow. Smaller companies may already be in a niche which undergoes a step change in demand due to external factors, essentially being in the right place at the right time.
Smaller companies’ ability to focus on a niche market should be particularly important now, when deflation is a threat. At such times, the ability to set and maintain prices becomes increasingly important. Normally, larger, more dominant companies have much greater pricing power than smaller companies. However, even smaller producers may be able to dominate a niche, command a high degree of pricing power and thereby provide some protection against deflation.
YOOX Group is one example of a company which dominates a niche. YOOX offers online fashion retailers such as Net-a-Porter greater global reach and local expertise, with its unrivalled network of logistics and digital centres around the world. YOOX is likely to have greater pricing power as luxury retailers who want to distribute globally will be significantly disadvantaged if they use a less comprehensive distributor, even if they are cheaper. On the other hand, large distributors like Amazon, with less focus on luxury brands, may be unattractive to these kinds of retailers.
Better balance sheets
Surprisingly, quoted small caps may also boast sounder finances than large listed stocks. Certainly, they are less likely to undertake share buybacks, which tend to increase financial gearing. Some $ 58 billion of debt raised in the second quarter of 2015 was spent on buybacks or dividends6, at the time the highest figure on record. Much of this seems to have been expended by larger companies, which are much more likely to have buyback schemes than mid and small caps. For companies with a large market share, this is likely to be one of the few ways they can boost growth in the current low-growth economic climate.
Smaller companies may offer investors a better way to tap into changing consumer trends. For example, a number of well-established small caps are thriving on the back of the growth in specialist nutrition. Smaller companies that were traditionally producers of commodities, such as palm oil producer AAK or natural extracts company Naturex, are seeing increasing demand as society becomes more health conscious. Similarly, trends for larger companies to cut costs can be a big boost for smaller, niche providers. One such is RIB Software, whose products help to increase efficiency in the use of resources in construction projects. While these changes may benefit large companies as well, they are likely to have a greater impact on the earnings of smaller companies which may specialise in producing only one or two products.
The good name of a wellknown company is easily tarnished by bad publicity, as Google, Starbucks and Volkswagen can testify from recent events. By contrast, smaller companies often operate under less media and market scrutiny than their larger rivals. Indeed, they may benefit from larger companies’ efforts to avoid adverse headlines. For example, supply chains are now consolidating around reliable and reputable suppliers as larger companies seek to mitigate the risk of possible scandal. An example of this is the high-quality textile manufacturer ECLAT, which has benefited from shifting its business towards ethical, high-quality fabric production, at the expense of larger scale manufacturers which have traditionally focused more on quantity rather than quality.
Given the outlook for low economic growth and increasing technological disruption, we believe investors should pay particular attention to small caps. This environment will make life hard for large companies, whereas smaller companies have the opportunity to gain market share and grow faster than the market. At a time of unprecedented technological, social and regulatory change, small companies may be able to operate “below the radar” and dominate niches which are likely to grow in light of these changes. For investors, each investment will need to be evaluated on a company-by-company basis. They should not rely on the assumption that the small cap premium will operate across the waterfront. Being able to sort the wheat from the chaff will be vital to the success of a small cap portfolio.
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 McKinsey Global Institute (2013), Disruptive technologies: Advances that will transform life, business, and the global economy.
4 Source: FTSE Group and NASDAQ.
5 Grand View Research (2015) Industrial Protective Clothing Market Analysis.
6 Source: Bloomberg, Sundial Capital Research.