Small cap stocks have greater potential for earnings growth than large caps. This is partly just a question of arithmetic: for a small company to add 10 per cent to sales of £400m means a much less substantial increase in absolute terms than for a large company to increase sales of £20bn by 10 per cent. For some small companies it also reflects their position as innovators with new or disruptive products or services that are set to displace established vendors. Either way, the higher growth potential essentially means that the pool of small companies today contains the large companies of tomorrow.
Small caps certainly have the potential to be risky – their innovations may not take the world by storm and their growth rates may slow. Their lower liquidity and tendency to be less widely researched may cause their prices to be more volatile. Finance theory suggests that in the long run investors should be compensated for these extra risks with higher returns however, and empirical studies suggest that this is the case.
Moreover, there are further potential benefits. The more domestic focus of many small cap firms gives the possibility of greater diversification benefits from holding a global small-cap portfolio in a world where large companies tend to be multinational and large cap markets are increasingly correlated. Small cap stocks also stand to benefit from higher levels of mergers and acquisitions, and M&A volumes have recently been on the rise.
Why are we considering small cap stocks now? In normal circumstances we might feel that when markets are setting all-time highs the small cap indices will have run ahead and it might be time to take profits on small caps and look to invest more defensively. Currently this is not the case however. Small caps performed strongly in 2012 and 2013, but have lagged their large-cap cousins since then in many markets, leaving valuations today looking reasonable relative to their long-term averages. This is in contrast to large cap stocks, which generally look quite fully valued. This seems to be a good opportunity to add to an asset class which has the potential to outperform in the medium term as a result of its relative valuation, and in the long term because of its inherent advantages.
What is the best way to gain exposure to global small cap stocks? The conventional wisdom is that small caps are less heavily researched than large caps, resulting in a less efficient market and giving plenty of scope for active managers to add alpha. When our pooled vehicles team reviewed the global small-cap funds with long-term track records we concluded that there is no clear evidence that fund managers are able to consistently add value however. Those that did beat their benchmark tended to gain by taking large allocation bets between different economies and markets rather than through stock selection. We have therefore decided to use a passive fund to gain exposure to global developed market small-cap equities.
The new weighting will be funded by decreases in the UK and emerging market equity weightings. We retain overweight allocations to both of these areas, but are reducing the magnitude of the overweight positions into strength and in the face of moderately higher risk.
As equity markets are making fresh highs and earnings growth has not been outstanding, we are happy to maintain an overall tactically neutral equity position. With fixed interest weightings still at their tactical low points, this means that the current cash holdings have been maintained.
Matthew Hoggarth is an investment analyst at Thesis Asset Management.