The advantages of small caps

HISTORICALLY since 1975, small-cap equities have outperformed large-cap equities by an average of 4 per cent in years of GDP expansion, according to MSCI data. In line with our expectation that the global economy will accelerate in 2014, we are convinced that smaller companies will be the beneficiaries of the current expansionary phase of the global economy, reinforcing our conviction that investors should give small cap equities real consideration in their portfolios.

Despite this phenomenon, small caps have been consistently overlooked by investors for years. Smaller companies represent an under-owned asset class, though this is not a wholly intentional decision by investors. Institutional investors, in particular, have "unconsciously" adopted an underweight position in smaller companies. The reasons are manifold.

Moves away from equities and into bonds, and away from regional and into global portfolios, have clearly contributed. Academic work also highlights a general preference on the part of institutional investors for large and liquid equity holdings.

This underweight remains the case even though the benefits of holding smaller companies as part of a diverse portfolio have been documented at length.

In addition, small caps have been subject to a number of myths or misconceptions, the most significant in our view being that small caps are "only" a high beta play, the beta being explained by small cap returns that are strongly correlated to the economic cycle, and, consequently, highly vulnerable to economic downturns.

Admittedly, small caps have been more sensitive to the economic cycle than large caps over the last 40 years. However, the behaviour of small caps since the first jolt of the financial crisis defies this conventionally-accepted wisdom, and reflects what we consider to be a series of structural changes at play in the small cap investment universe.

Newfound resilience

Based on historical trends, in 2008 and early 2009, when the United States economy collapsed and developed economies experienced the deepest recession since World War II, the relative performances of small cap firms should have also plummeted given the sensitivity of the excess returns of small caps (over those of large caps) to cyclical economic fluctuations. Curiously, this did not occur: US small caps performed in line with large caps, and have strongly outperformed since then.

This evidence suggests that small caps are now in a better position to absorb downward macro shocks while maintaining their rebound potential when economic growth accelerates, as in 2010 and in 2013.

This observation is confirmed by our analysis of the relative monthly performance of small caps to large caps according to changes in the ISM manufacturing index, an indicator of economic conditions (ISM readings above 50 indicate growth in the manufacturing sector while readings below 50 indicate contraction).

Over the 2000-2013 period, our sensitivity analysis reveals that if the ISM is higher than 50, then an increase in the ISM by one point implies an increase in small cap monthly outperformance by 140 basis points on average, while small caps and large caps behave similarly for ISM numbers below 50.

Earnings less impacted by economic downturn

While economic conditions continue to have a significant impact on small caps, their earnings are now much more resilient to economic downturns than in the past. This is evidenced by the way the two components of earnings growth - top-line growth and margin variations - behaved during the two main cyclical downturns of the last 20 years, in 2000-2001 and 2008-2009.

During the downturn of 2000-2001, US GDP growth decelerated to virtually zero, while total sales slumped by almost 10 per cent and profit margins slid into negative territory (-5.5 per cent). During the downturn of 2008-2009, US GDP fell 4 per cent, while total sales declined by only 7 per cent and profit margins dropped to -7 per cent.

If in 2009 the sensitivity of top-line growth and margins to US GDP growth had been the same as in 2001, the fall in revenues and margins would have been roughly double. Thus, small caps proved significantly more resilient in 2009 than in 2001, demonstrating that the sensitivity of small cap earnings to cyclical headwinds has declined.

One reason the earnings of small cap firms have become more resilient is the geographic diversification of their revenue base. The share of foreign sales in total sales of US small caps has increased from 11 per cent to around 17 per cent over the last two decades.

The same broadly holds true for European small cap companies which have built a very strong presence in Asia or the United States.

Strong play on structural growth

Another, and in our view, the most important, factor for this newfound resilience stems from the fact that small caps have preserved their ability to grow faster than large companies through their increased exposure to structural growth stories.

US small caps have been able to post a 15 per cent compound annual growth rate for earnings per share (EPS) since early 2000, compared to 5.5 per cent for large caps, while at the same time the aggregate volatility of small cap top-line growth has declined.

This stellar EPS growth has been fuelled in part by what we call disruptive technologies, that is, leading to entirely new products and services.

As part of this shift from cyclical to structural growth exposure, small cap companies move up the value chain. As a result, their profiles change and they increasingly make their presence felt in high value added sectors.

One advantage that their lesser size offers smaller firms is greater agility to fully leverage secular growth opportunities as they arise. Their agility helps them to i) swiftly navigate paradigm shifts, ii) quickly seize upon regulatory changes even in mature markets, and iii) innovate successfully.

Navigating paradigm shifts

A concrete example of the ability of small caps to adapt and profit from disruptive technologies is the US energy sector. Many small oil exploration & production (E&P) companies have generated double-digit revenue and earnings growth from the unconventional oil and gas boom.

North American small and mid-cap E&P companies have decreased their costs and increased revenue with substantial improvement in earnings growth.

Whiting Petroleum is one such E&P firm. One of the first-movers in the fast-growing Bakken basin/Three Forks area - a strong, rich shale oil and gas basin where Whiting began drilling in 2007 - the firm applied its innovative cost control and completion methods, along with its willingness to take the lead in critical midstream elements like processing and pipelines, in order to establish itself as an active leader.

Seizing upon regulatory changes

The French telecommunications sector offers a clear example of the ability of small firms to quickly benefit from regulatory changes. In 2009, the French telecommunications regulatory agency (ARCEP) recognised that a market made up of three incumbent mobile providers was not optimal for competition and thus sold a 3G spectrum licence to Iliad, an alternative telecoms carrier, for 240 million euros (S$415 million).

Iliad, already a challenger in the landline phone business, became the fourth mobile operator and quickly seized 15 per cent market share in the mobile telecom market in just one year. This success story helped Iliad outgrow the small cap universe, pushing its market cap up to close to 10 billion euros.

Increasingly successful innovators

The ability of small cap companies to innovate is particularly visible in the technology and biotech sectors. In the latter, many therapeutic breakthroughs have been initiated by small biotech companies. In 2012, small biotech companies were awarded 50 per cent of drug approvals in the US.

This significant gain in drug approvals over the prior year has translated into very strong stock performance. Small cap biotech stocks are clearly outperforming the rest of the small cap arena.

The focus on R&D and intellectual property has clearly enabled small caps to sustain product leadership and competitive advantages.

M&A targets

Thanks to their focus on innovation and structural growth, small cap performance is, more than ever, driven by mergers and acquisitions (M&A), since they are often acquired by larger firms trying to gain access to crucial technology or new markets, resulting in substantial gains for small cap investors.

Big data and cloud computing have been major disruptive trends. Software as a Service (SaaS) has emerged as an alternative to traditional licensed software products. Small cap cloud computing companies are now challenging traditional software, data and solutions suppliers.

Subscription- and consumption-based models are cannibalising the traditional software licence purchase model at an accelerating pace, leading to a raft of consolidation in this space. Established software companies such as Oracle and SAP have snapped up several smaller companies in order to gain exposure to these fast-growing markets.

A prominent example is Ariba, a small software and IT services company specialising in web-based procurement, which was purchased by SAP with a 20 per cent premium last year.

With many large cap firms sitting on huge piles of cash in today's low growth economic environment, there is a natural tendency for companies to acquire growth: over the last 20 years, 88 per cent of all M&A targets in Europe were small and medium-sized companies - paying an average premium of 28 per cent.

We expect small cap exposure to structural growth to remain attractive for large caps as M&A targets in the future.

Investing in small caps

Harnessing the potential of small caps is not as straightforward as investing in large caps, however.

First, the opportunity set is much greater than for larger companies: the standard MSCI World Index comprises some 1,500 names, rising to over 4,000 for the MSCI World Small Cap Index, an investment universe that is challenging for most active investment managers to cover.

Second, smaller companies are, by their nature, more volatile than their larger brethren. In fact, while the agility of smaller firms brings many advantages, there is a flip side. Developments presented here, such as moving up the value chain, pioneering trends, and leading product innovation, often entail company-level decisions with no guarantee of success, making them a significant source of specific risk among small cap companies in the medium to long term.

Therefore, alpha opportunities in the small cap arena abound. First, small caps exhibit a wider dispersion of returns than other equities. Second, lower (or non-existent) analyst coverage of small cap firms contributes to wider gaps between a firm's share price and its fundamental value. Third, we currently see significant mispricing in the market.

Let's examine each of these factors in turn.

Higher return dispersion

The spread of monthly returns is clearly greater among smaller companies when compared to large. At the same time, we note higher levels of specific risk associated with smaller companies, although specific risk associated with both large and small cap companies is currently at historically low levels.

This dispersion of returns presents an array of mispricing opportunities for active stock pickers to capitalise on.

Under a smaller microscope

Although smaller companies have to some extent diversified their revenues, as outlined previously, their earnings are often still perceived to be more volatile and less easy to predict, something that is compounded by the lack of coverage by analysts and magnifies the potential for mispricing at the stock level.

In the United States, for example, a typical large cap stock is covered by an average of 24 analysts. The number of analysts falls to just seven for smaller companies, though many smaller firms are simply not covered at all.

This means that among larger companies the gap between a company's share price and its fundamental value is often small, even fractional in the largest and most well-covered companies, whereas this dispersion can be a lot higher among smaller companies.

Significant price inefficiencies

A number of factors, including a lack of investor familiarity with small caps, less analyst coverage, higher volatility, and lower liquidity, contribute to significant price inefficiencies.

This type of environment creates opportunities for a successful stock-picker to add value over and above the beta available from a passive allocation to smaller companies. The greater price "spread" of smaller companies creates more opportunity to arbitrage this spread away.

From a valuation perspective, we can see that today's market offers high levels of valuation opportunity. To show this point, we rank the universe of stocks from high fair value to price ratio (undervalued stocks) to low fair value to price ratio (overvalued stocks).

Then, we split the ranking in half and divide the average undervaluation of the first group by the average overvaluation of the second group. For small caps, over time, the spread between the two halves has moved to levels not reached since the tech bubble of 2000.

This implies that there is significant mis-pricing within the small cap market, which provides a good environment for active strategies. Further, it shows that within the global small cap universe the opportunity to add value through stock picking appears to be much greater than for large caps, both currently and historically.

Looking ahead

For investors contemplating an allocation to small cap equities, an important consideration is whether this valuation gap will compress. If this occurs, it will benefit active investors.

The clearest way to flesh out an indication is by examining the equity rally currently underway. The initial stage of the equity rally witnessed so far has been driven by a sharp re-rating of valuation multiples. We think two independent forces have been at work here: i) massive liquidity injections led by the Federal Reserve (QE3) and ii) fading systemic risk in the eurozone.

With the first stage of the rally gradually coming to an end, a key theme that will move to the fore as 2014 unfolds becomes clear: earnings growth will take over from the declining liquidity booster.

Company fundamentals will become increasingly important, favouring the convergence of small cap prices towards their fair value, and thus benefiting active investors.

One element to watch over the course of this transition will be company leverage. For smaller companies with limited access to capital markets, leverage is an important tool for participating in a recovery and can help a firm grow.

However, with the potential for interest rate rises on the horizon, it is important for investors to be able to differentiate between strong companies that use leverage well and have sufficient income to cover their debt and weaker ones that may be distressed or at risk of default.

This means that, for investors, avoiding bad stocks will become as important as picking good ones.

The breadth of the universe multiplies the investment opportunities. Combine this with strong exposure to structural growth stories, significant levels of mispricing, low coverage yet a favourable investment outlook and the opportunities for stock pickers to add value from smaller companies seem plentiful as we move into 2014.

Greater investor focus on this overlooked asset class should help narrow the spread and turn the small cap beta to alpha for investors.

Alec Harper is from AXA Rosenberg, Mathieu L'Hoir is from AXA IM Research & Investment Strategy, and Maguy MacDonald is from AXA Framlington