Small cap vs large cap: how valuations compare

Smaller company shares have outperformed over time. Global “small caps” have returned almost three times as much as large companies over the last 16 years.

Since March 2001 the MSCI Global Small Cap Index has returned 317%, including dividends, compared with 107% for the MSCI Global Large Cap Index, our research shows.

Investors might be prepared to pay more for shares that have the potential for faster earnings growth.

As the investment saying goes: “elephants don’t gallop”. In other words, it’s easier for a minnow company to double its size than a large company.

If you invested $1,000 on 31 March 2001 in global small caps your investment, including dividends and adjusted for inflation of 2.3% (historical global average), would now be worth $2,903.

If you had invested the same amount in global large caps it would be worth $1,438, based on MSCI indices.

Of course it is important to note that past performance is not a guide to future performance. Additionally, investments in smaller companies can be less liquid and more volatile than investments in larger companies.

An investor may think the small-cap ship has long since sailed, given those gains. But valuations indicate it may not be too late to jump on board.

What is a small cap stock?

The definition of small cap can vary between markets and moves over time. The MSCI World Small Cap Index covers 23 developed markets. The index’s largest constituent has a market capitalisation of $11 billion, the smallest just $44 million.

Do small caps remain good value?

On average small-cap valuations have so far remained relatively attractive, despite their rapid rise.

One way to value individual shares or the stockmarket as a whole is to compare share prices and earnings in a price-to-earnings ratio (P/E). A lower P/E ratio suggests better value.

Global small caps’ 10-year median P/E is 25.8, compared with large caps’ P/E of 16. So on average global small caps have traded on a 61% premium to large caps since 2007.

The premium is currently 46%. Small cap P/Es have risen to 30.8 from 27.5 in 2007, while large cap P/Es have climbed to 21 from 16.3.

Regional bias

Global and European small caps trade below their historical (10 years from Q4 2006 to Q4 2016) median premiums, compared with large caps, according to MSCI data. The US and the UK appear more expensive.

Why consider investing in small caps?

Matthew Dobbs, Schroders’ Global Head of Small Cap, said:

“The outlook for investors is difficult with such unprecedented technological, social and regulatory change sweeping the world. But for smaller companies, it may present an opportunity. They may be able to operate ‘below the radar’ and dominate niches which are likely to grow in light of these changes.

“Companies that are nimble and less burdened by layers of management may be better equipped to keep up with these changes. In contrast, having a strong brand and a wide distribution network are not necessarily assets anymore.

“A new generation of winners are emerging - ‘capital light’ companies with 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.”

“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 universally.”

Paul Marriage, Head of Dynamic Small Cap at Schroders, said:

“You can think of small investing in the same way as parenting. When the companies are at a very early stage, they are problematic. Likewise, any parent will tell the ‘terrible twos’ is a difficult time. And once companies get too big, they are then teenagers, becoming potentially hard to manage.

“But in between these two phases is potentially a sweet-spot for parents and investors alike. This is the stage at which we invest, after the toddler stage but before the teens.

“We believe that there are more opportunities to find investments with the potential for material upside within small caps.

“Due to their size they are less well covered by analysts and the media, so investors tend not to be as aware of them.

“Once a small cap company starts to deliver you could potentially get a double whammy effect of growth and rerating. A small cap stock might go from a P/E of 10 to 20 times once they start to grow and get discovered.

“That is much more difficult to achieve with larger companies.”

Four ingredients for a successful small cap investment:

1. The company should be a market leader in their niche and growing.
2. The company should have a unique product or service to differentiate it from rivals.
3. The company should have good management who preferably hold substantial a stake in the business.
4. The company should be cash generative and profitable.

Please remember that past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.