Large-cap returns outpace small caps

The returns on large Australian companies have beaten small caps over the long term, contrary to popular belief that small companies offer the best gains, with mining stocks dragging down the small cap index.

However, investors should maintain some exposure to small companies to capture their upside, fund managers say.

Traditionally, it is believed that small caps, although riskier, outperform large caps because they are growing faster, which consequently rewards investors. This thesis is borne out in research from famed academics Eugene Fama, Kenneth French and many others.

But in Australia, that doesn’t hold true of the market benchmarks for small-cap and large-cap companies. The total returns on the S&P/ASX 50 over 10 years to 1 October 2020 are 2.15 per cent a year, while the ASX 200 returned 2.5 per cent. In contrast, the S&P/ASX Small Ordinaries averaged an annual total return of just 0.5 per cent over 10 years, barely making a gain.

Research from fund manager Schroders backs these findings. Their research paper, Investing in Australian Small Cap Equities – There’s a better way finds that the ASX Small Ords index has delivered less return and more risk than large-cap stocks, which is an anomaly when compared with global small-cap markets. 

“This is largely due to the construction methodology (and thus the constituents) of the index,” the paper finds.

“Large-cap stocks have had better earnings growth historically than small-cap stocks, no doubt partly due to the way poor quality index constituents are included.”

The Schroders’ paper points to non-revenue generating mining companies being included in the Small Ords index, representing a drag.

Performance of small caps during market corrections and recovery periods

MSCI ACWI Small Cap v MSCI ACWI

Dates: Dot-com crisis: 3/10/2000 to 10/9/2002. 2008 Financial Crisis: 10/31/2007 to 3/9/2009. Ebola: 7/3/2014 to 10/13/2014. Covid-19: 1/5/2020
Data from 3/10/2000 to 6/30/2020. Cumulative returns in USD. Past performance no guarantee of future results. Source: Bloomberg.

Ian Carmichael, partner and portfolio manager at Fairlight Asset Management, agrees. He says the underperformance in the Small Ordinaries Index versus the ASX 20 or ASX 50 is a result of the composition of the Small Ordinaries, which has a large allocation to mining stocks, which typically fail to earn their cost of capital over the cycle and represent a drag on total index returns. Offshore small-cap indices are much higher quality than the Australian small-cap index, given the absence of mining stocks.

“This phenomenon only exists in markets which have a poorly diversified small-cap market,” says Carmichael.

“Most offshore markets have healthy exposures to industries that have traditionally delivered the best returning companies: healthcare, technology, industrials and consumer.

“Australian small-cap managers are given a free kick by simply not investing in mining stocks. This decision alone is worth a few percentage points of alpha a year.”

According to Schroders, at an index level, it has made little sense to own the small-cap index relative to the large-cap index over any reasonable time frame, once the risk of small caps being consistently 25 per cent higher than that of large caps since the GFC is considered.

“While many investors in Australia take a decision to go structurally overweight small-cap stocks given the sector and stock concentration in the large-cap index, our analysis suggests that a separate allocation to small caps isn’t necessarily the best or most cost effective way to achieve this.”

However, with an active approach, investors can potentially boost small-cap returns, which can be much higher growth than large caps, as the companies are still maturing, according to fund managers.

“Small companies have longer growth runways, are often acquired by large companies, and are less covered by analysts so offer greater opportunity for mispricing,” says Fairlight’s Carmichael.

He manages the Fairlight Global Small and Mid Cap Fund, which does not invest in certain sectors of the small-cap market, including cyclical business (commodities and mining) and interest rate sensitive businesses (banks and utilities). The fund has outperformed its benchmark, the MSCI World Small & Mid Cap Index, by 11.4 per cent a year since inception in November 2018.

Trevor Gurwich, a senior portfolio manager at American Century Investments, says an active approach to an inefficient asset class like global small caps can translate into greater potential returns for investors versus the more efficient large cap asset class. It has the potential to enhance returns and lower overall risk, due to low correlations with Australian and global large caps.

“An allocation to global small caps allows access to a much larger universe of stocks and substantially different sector exposures compared to Australian and global large caps. That divergent sector exposure leads to lower correlations,” he says.

“The current market environment may favour global small caps versus large caps as small caps tend to lead the markets during periods of economic recoveries,” he says, pointing to the chart below.

“Valuations also look attractive for small caps relative to large caps. Additionally, small caps tend to outperform when interest rates are rising or normalising and credit risks are falling for small caps, typical in periods of economic recovery. This aligns with performance patterns between large and small over the past 20 years,” says Gurwich.