The Small Company Effect ...

Introduction

The Small Company Effect

Higher long term returns without
commensurately higher risk ...

A phenomenon that has become known as the "Small Companies Effect" has inspired a great deal of analysis by investment researchers worldwide over recent years.

In this article, Dr Neville Hathaway, who recently joined County as head of the Investment Solutions Group, examines the Smaller Companies Effect, drawing upon the United States experience where more extensive historical data is available.

The Effect in a Nutshell

A remarkable discovery was reported in 1981 by Rolf Banz in which he found a strong relation between company size and stock returns. Over long periods of time, he found, investments in small capitalisation stocks seem to provide greater than average returns without a corresponding increase in risk.

To be sure, the absolute level of risk from this form of investment is greater than for investing in large firms. However, the extra return from small firm investing exceeds that which would be warranted by the extra risk.

Historical Evidence

Much longer data series are available in the USA to analyse the smaller companies effect, as illustrated by the comparison between small capitalisation stocks and other securities in that market over a 65 year time span (Figure 1).

On an annualised basis, calculations by Ibbotson and Sinquefield put the mean returns from small capitalisation stocks at 12.1% pa, against 9.9% for "common stocks" in the US. Similar results are reported for the UK. Hoare Govett small firm index in which small firms have outperformed large firms by an average 4.5% pa premium over the last 37 years.

Another way of viewing the small firm effect is to calculate relative returns of the small firm index versus the market index. This is done in the plot (Figure 2).

As can be seen, there have been three distinct periods (four if the 1990's is included) of small stocks collectively outperforming large cap firms. These periods typically coincide with strong economic growth, such as the high production associated with World War II and the strong recovery following the oil-induced recession of the early 1970's. In contrast, when economic times are poor, small firms generally underperform large stocks.

Possible Explanations

While providing strong evidence that smaller companies investment requires patient capital, historical figures in themselves do not explain the reasons for the superior risk/return profile of the sector relative to larger capitalisation stocks.

A mounting body of academic research has emerged to address this question, employing a range of quantitative and behavioural techniques. The following list is by no means exhaustive, but highlights some of the major thrusts of this research.

Information uncertainty - Small cap stocks are not researched as thoroughly as larger stocks. Lack of information amounts to relatively higher risk and potentially greater opportunity to exploit market mispricing.

Transaction costs - Small cap stocks can be more expensive to trade, generally involving wider bid-ask spreads and being subject to larger market impacts from trades which are made. These factors may provide a disincentive for investors to engage in frequent transactions, and consequently lead to lower price volatility than might be the case for comparable large capitalisation stocks.

iIliquidity - Small cap stocks are relatively illiquid. Hence, their excess returns can perhaps be explained simply as compensation for this illiquidity. As business enterprises, they are often dependent on a single product line and are consequently more susceptible to economic downturns.

As illustrated in figure 1, they outperform at the end of recessions, and underperform entering recessions. Going into a recession period, we see a "flight to quality" and small cap stocks become "unloved" by the market. At this time they can become highly illiquid, as happened after the 1987 stock market crash.

Summary

It is now widely recognised, and demonstrated by historical experience, that small cap stocks make higher returns (in the long run) than large cap stocks. Moreover, this extra return appears to be more than is warranted by the extra risk that investors are required to assume.

Different degrees of empirical evidence have been presented for each of the factors outlined above, but there is as yet no universally-accepted explanation for the small firm effect. We believe, however, that the most likely explanation lies in the relative illiquidity of smaller company stocks compared to larger listed companies.

There is unlikely to be a "free lunch" in small cap investing, but a disciplined investment approach should allow investors to take advantage of the smaller companies effect as part of a properly diversified long-term investment portfolio.

This is exactly what County will be aiming to deliver through its Smaller Companies Trust as it enters its second decade.