Why size is not a reliable guide to investment success

Just 10 US behemoths now account for a fifth of the MSCI All Country World Index, the highest concentration in decades. Across much of the world, large companies have left smaller peers in the dust. Is the notion that minnows outperform — known as the small-cap premium — dead or merely resting?

The outsize returns of small companies relative to larger peers was documented in the early 1980s using evidence from the half-century to 1975. The idea found theoretical support. Higher returns compensate investors for taking on the greater risk of backing smaller, younger companies — though that can be minimised in a diversified portfolio. More importantly, they recompense investors for elevated spreads, higher trading expenses and supervision costs.

Over the long run, small-cap companies have outperformed larger ones, according to the UBS Global Investment Returns yearbook. Over 43 years in 34 markets, the monthly premium relative to large companies averaged 0.21 per cent. But the premium identified in the 1980s was far bigger. It can disappear — sometimes for years at a time — after periods of strong performance. That pulls down the long-term average.

Short-term, economic factors shape sentiment towards small companies. They are often hard hit in recessions because they have a less diversified revenue stream. Smaller company valuations are more sensitive to interest rates, too.

By that logic, the prospect of falling rates should provide a lift. A boost would be particularly welcome in the UK, where low valuations make companies takeover targets. That said, index valuation is distorted by lossmakers. The FTSE SmallCap Index trades on a price/earnings ratio of minus 139 if investment companies are excluded.

Over the last quarter of a century, “deaths” from takeovers and delistings have outstripped “births” in the Deutsche Numis Smaller Companies Index. But the ranks of the index, which represents the bottom 10 per cent of the main UK market, were also swollen by “fallen angels” in its December rebalancing. Companies previously too big for the index included Watches of Switzerland, Indivior, Ashmore Group and Dr Martens.

Fallen angels might well rebound. But in general, investors have not prospered by betting on underperformers to change. Momentum investing — going long on winning stocks and shorting losers — has been an effective strategy over the long run, according to Scott Evans and Paul Marsh of London Business School in a review of the Deutsche Numis indices.

By comparison, relying on the small-cap premium has been a lot less profitable. It is reasonable to expect a long-run annualised premium of roughly 1 percentage point with a lot of year-to-year variation, the authors say. The size effect is real but as an investment formula, it comes up short.

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