Is small beautiful?

I can only post fairly infrequently at the moment as I have a lot on my plate, what with planning our DIY summer wedding and simultaneously embarking on the most important work project of my career so far. It’s been a lot harder to make time for the blog. I do intend to keep it running, but at a slower pace for the time being.

A recurring issue I’ve been grappling with recently is whether I should be trying to shift my focus more to smaller businesses. Instinctively, it feels like the smaller cap space should be a more productive hunting ground for a small private investor like me. I’d expect small caps to be less well researched and the markets more illiquid, giving greater scope for shares to be mispriced. On top of that there should be greater scope for growth when you start from a smaller base. However, in practice I’ve found that identifying high quality is much harder in the small caps space. Should be trying harder?

I often seem to go for much larger investments than many of my UK private investor peers. The companies on my watchlist cover the full range of sizes, from tiddler Arcontech (at £23m market cap) to the largest listed business in the world, Microsoft (£828bn market cap). A large proportion of the 100 companies I follow are at the larger end of this range – the median on my watchlist is £6.5bn, which would be large enough to get into the FTSE 100 and escape the attention of many UK small-cap focused investors.

It wasn’t always this way. I started out investing only in UK small caps. My decision to start investing in US shares a couple of years ago had a dramatic impact on the average size of business I invest in. Broadening my geographic coverage seemed a good idea at the time. The US is an ideal hunting ground for high quality. While the UK only has a small number of high quality large cap businesses, the US market is teaming with them, particularly in the technology sector. But it’s hard to get over the niggling doubt that since these businesses are all bigger and better-known, my informational edge must be limited and the excess returns I can get from them reduced. Might it be better to just stick to a smaller niche of under-researched quality UK small caps?

Empirical evidence

The ‘size effect’, the finding that small stocks tend to outperform large stocks on average, is near universally acknowledged. It is one of factor investing’s oldest findings, pre-dating even value and momentum. However, the most interesting thing about the size effect is that it may not actually exist. This paper by quant fund AQR reassesses the evidence behind the size effect and dispels a few of the myths surrounding it. It finds that simply investing in small stocks isn’t likely to lead to outperformance by itself. Small caps may achieve somewhat better returns over the long term but this is due to them having higher beta (return correlated with the wider market). In principle this is something that can be replicated simply by allocating a greater proportion of one’s portfolio to a market tracker, using leverage if necessary. Apparently, the original finding of the size effect was driven in part by data errors from neglecting to account for the greater proportion of small stocks that delisted (often a negative outcome), providing some fuel for my own inherent skepticism of applying statistical analysis to investing.

However, the empirical evidence doesn’t suggest that investing in smaller stocks makes no difference at all. For one, the AQR paper finds that there may be some premium from taking on greater liquidity risk i.e. the risk that you won’t find buyers or sellers of the shares when you need to. Liquidity matters less if you are a private investor with relatively little to invest. Investing in small stocks should provide a legitimate way for private investors to exploit their ‘liquidity advantage’, at least to some extent. The other benefit of investing in smaller stocks may be that other factors, such as value and momentum, work better, as set out in this article by Alpha Architect. And if the classic ‘factors’ perform better among small caps, perhaps this suggests that simple stock-picking acumen should perform better too? Even if small caps do no better than large caps on average, there may be greater opportunities for the savvy investor to exploit, provided they can avoid the pitfalls.

Behind the stats

So why would factors such as value and momentum work better with small caps? What inferences, if any, can be drawn for an investor like me who tends to rely heavily on more qualitative analysis in an attempt to identify the highest quality businesses? You need to understand the intuition behind the stats to answer these questions.

The obvious starting point is that there is simply more variance in likely outcomes from investing in small caps i.e. they are higher risk. It seems fairly intuitive that the range of outcomes you are likely to get from investing in small caps would tend to be greater. Small caps are by their nature often more speculative, less proven businesses than their larger counterparts – more are likely to end up at the extremes of either turning out to be basket-cases or wildly successful in growing from a small base. Smaller companies are also less internally diversified than larger businesses, often relying on a narrower range of activities and customers to generate their revenues. This means that either negative or positive events (e.g. winning or losing a major customer) will have a proportionally greater impact on the business. The greater variance in likely outcomes means that the value of sorting the wheat from the chaff should be greater for small caps. In other words, with higher risk comes the potential for higher reward.

This idea is simple. If you’ve got the skill and a small enough portfolio then you should be rewarded more handsomely when you take on the greater risk of investing in small caps, especially when there is also the ‘free lunch’ of diversification to take advantage of. Buffett believes in this. He reckons he could generate 50% returns year in year out if he had a smaller portfolio and could invest in small caps. Taking on more risk is of course double-edged. For every winner that benefits from the greater potential rewards of investing in small caps, there will be a loser who sucks up the greater potential losses. While you don’t need to have Buffett-like skills, the zero-sum nature of investing outperformance means that you do need to be better than the average punter to outperform the market.

This is an important point. While we all like to think we are better than average, the reality is that half of us are wrong about this. It’s much easier to be confident that you are not going to be in the losing half if you have a strategy that is systematic in taking advantage of a market inefficiency.  So are investors in small caps more prone to make systematic behavioural mistakes that can be taken advantage of? Possibly. The quantitative findings that value and momentum factors tend to work better with small caps seem to suggest so. My own anecdotal experience of investing in both UK small caps and US large caps also seems to support this. The most striking difference I’ve noticed in how these markets behave is that the US market seems more efficient at responding quickly to news flow, resulting in subsequent price movements that are less predictable, while prices for UK small caps are often slower to react, providing opportunities for those who can react quickly to positive news or a profit warning.

Focusing on factors such as value and momentum may be one way of capitalising on the potential rewards on offer from investing in small caps. More broadly, any strategy that enables you to identify those small caps more likely to succeed on average should allow you to take advantage. There are some low hanging fruit here. I reckon you can increase your odds significantly simply by limiting your ‘investing universe’ to those types of industry and business with higher base rates of success, for example avoiding speculative blue-sky punts, miners and oil explorers etc. In principle, there should be even greater rewards to those who are able to pick those individual businesses most likely to succeed through more detailed research.

Which brings me on to quality investing. The idea behind this strategy is to take advantage of a systematic bias – that investors are short-sighted when thinking about valuation and place insufficient attention or weight on important qualitative aspects that predict long term growth, such as competitive advantage. This bias leads high quality to tend to be undervalued. My speculative view is that this bias is just as present for large caps as for small caps. While the higher risk of investing in smaller stocks can imply higher potential rewards in general, I don’t think smaller high quality stocks tend to be especially undervalued relatively speaking.

Instead, I think quality investors face a more specific trade-off between the greater certainty of growth you can get from a quality large cap and the greater scope for growth you can get from a quality small cap. Quality large caps tend to stick out like sore thumbs. They are often the dominant players in growing industries with the highest market share, the best financial metrics and the best track records. Much of the time their competitive advantage is intractably linked to their scale. It may be surprising that they tend to be undervalued given their prominence. But they do tend to be undervalued. Investors seem biased to underestimate the implications of the greater certainty and longevity of future growth that their advantages bring them, instead often being put off by the more readily apparent higher valuation multiples they command. In contrast, quality small caps are much harder to identify. They haven’t yet dominated large growing markets but instead either occupy smaller niches or are at a relatively earlier stage of their development. Typically there is inherently greater uncertainty about their long term success. The rewards for investing in the few that ultimately are successful are correspondingly greater.

Assessing the trade off between the certainty and scope for growth is extremely difficult. I don’t think it is really something that can easily be generalised across large caps and small caps as a whole. Instead, I think you need to think about this case by case. The generalisation that small caps face greater uncertainty and large caps have lower growth prospects does not always apply. Some small caps can be very dominant in narrow niches (e.g. Games Workshop) and some large caps can still grow like the clappers (e.g. Amazon). The internet has enabled companies to get much bigger much more quickly in recent years.

Overall, I don’t think there is much sense for quality investors to restrict their universe only to small caps. While the ‘holy grail’ is to identify a highly certain future winner while it is still in its infancy, you’re not going to find many of these without some special insight or a lot of hard work researching. I think it makes sense to also take advantage of some of the more readily apparent high quality on offer in the large cap space.

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