Multi-manager opinion: Will small caps continue to beat mega caps?

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Peter Askew is co-manager of the T. Bailey Growth and Dynamic funds

After a period of strong relative performance by small and mid-cap stocks, it should be no surprise that there is now talk of mega-caps outperforming.

There is also likely to be an element of growth versus value in the argument, with small and mid-cap stocks having more of a growth bias.

One can argue that mega-cap stocks carry higher beta, due to their relative index weight, and are more sensitive to market rises, but the same is true if the move is the other way. Mega-caps could also be more susceptible to changes in the outlook for the economy and interest rates.

Our view is that more attractive long-term opportunities exist further down the market cap spectrum. Investment strategy should be about opportunity not market capitalisation and that leads us invariably to funds focused on small to mid-cap companies. Because we are not constrained by being too big, we continue to find funds that operate in the small to mid-cap arena that offer, and have delivered, better risk-adjusted performance.

There may be the odd bout of mean reversion when mega-caps or index beta does well. If you think you can trade that opportunity then fine – most cannot.

It reminds me of George Ross Goobey and his seminal asset allocation work over half a century ago, which led to the greater use of equities in pension funds. What often gets missed in his work is that he focused on small and mid-cap equities as the best long-term performing assets.

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Caspar Rock is CIO at Architas

A glance at the performance of the small and large cap indices of the world’s major markets in 2015 shows a divergent story. Small caps have outperformed their bigger compatriots in both the UK and European markets and now trade at premium valuations.

Small cap companies tend to have a domestic bias to their earnings. Over the course of a turbulent year in global markets, dominated by fears of a slowdown in Chinese growth and the collapse of the commodity supercycle, this has proved a bonus. By contrast, the mega caps of the FTSE 100 market are characterised by their international nature, to the extent that more than 70 per cent of their turnover is earned overseas.

In Europe, where a recovery is slowly gaining ground, small caps continue to benefit from steadily growing cyclical demand in their home markets, largely immune to the gyrations of global demand.

Small caps typically have lower levels of financial gearing and it is therefore somewhat counterintuitive that they tend to underperform in a rising interest rate environment. This has nonetheless been the case in the US, where they have marginally lagged the mega caps this year, despite ongoing expectations of lift off in the Fed hiking cycle.

However, we have also seen significant underperformance by small and mid-caps in Japan, where monetary conditions are loose with the QQE stimulus programme in full swing and likely to be extended.

Bearing this contradictory backdrop in mind we hold the Franklin UK Smaller Companies Fund in our portfolios. The UK small cap sphere is attractively valued and, as the timing of interest rate increases in the UK is consistently pushed back, we are comfortable in taking this position.

We also remain holders of the JO Hambro UK Equity Income Fund, a well-managed fund, which specialises in small and mid-cap stocks, supported by an historic yield of 4.7 per cent.

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Bambos Hambi is head of funds of funds management at Standard Life Investments

The valuation disparity between large cap stocks and both mid and small cap companies has been a significant issue for a number of years. The recent weakness in the FTSE 100, precipitated largely by concerns over China and the weight of that index to commodity producing companies, has made the subject particularly pertinent.

Over recent quarters we have observed a predilection for managers towards companies with UK domestic revenues streams that are typically lower down the market cap spectrum. The recent performance of some of these companies, particularly those within the consumer discretionary sector, has been impressive and we feel in many cases that earnings growth will have to be robust for them to justify and maintain their ratings.

This perception has been corroborated by the comments of managers we have met as well as the public comments of others that we respect. One example is Mark Costar of JO Hambro Capital Management who recently said that mid-caps were “‘overcrowded’” and that he held the lowest weight to the asset class ever.

Despite the potential attractions we would caution against dramatic shifts into large caps. The FTSE 100, with its commodity and emerging market exposure, is likely to suffer from tepid headline earnings growth and, therefore, while there are undoubted opportunities, it is crucial to be discerning.

Across the market we believe that careful stock selection will be imperative and that the outlook will suit high-quality active managers. Selecting expensive mid-caps that fail to maintain their earnings growth or large caps that continue to disappoint are both likely to be costly mistakes and we think that avoiding the losers will be as important going forward as selecting the winners.