The value of diversifying with small caps
Small companies make up 90% of the US market and account for 43.5% of US GDP
Source: US Chamber of Commerce. September 2024. https://www.uschamber.com/small-business
26/09/2024
The value of diversifying with small caps
What are small caps?
Small caps1 are listed companies whose market capitalization is between USD 300mn and USD 2bn in large markets such as the US, although the range limits vary depending on the market. In smaller markets, such as Spain, the upper bound can be lower, often under EUR 1bn.
Above this tier are what are referred to as mid caps, i.e., companies with a market capitalization of between USD 2bn and USD10bn. Large caps are companies whose market capitalization is over USD 10bn.
Discount on valuation
Small caps trade at a significant discount to large caps and with respect to their historical average
Source: American Century Investments. https://www.americancentury.com/insights/should-investors-take-a-closer-look-at-downtrodden-small-cap-stocks/
Active management is important
A significant number of companies in small caps indices are unprofitable
Source: Furey Research Partners. Data as of September 2023
Main investment arguments
Diversification
• Small caps account for a large proportion of listed companies. For example, they represent 90% of the US market3.
• Companies in this category are often exposed to market niches or emerging sectors.
• They are often at the forefront of innovation and development within their industries, and many of them are startups.
• Many of them offer exposure to megatrends such as digitalization.
Growth potential
Since they tend to be at an early stage of development, small caps tend to expand faster, which can provide greater appreciation for investors in the long term. Investing in a small cap that is at an early phase of growth can offer the opportunity to share in its success from the outset.
In the past, small cap indexes have tended to appreciate more than large caps: an annualized return since 2004 of +7.7% on the Stoxx Europe Small 200 vs. 5.7% on the Eurostoxx 502.
A broader set of opportunities
Not only is the number of index components greater than in the case of large caps (4,100 companies in MSCI World Small Cap vs. 1,500 in MSCI World2), but there is also a greater dispersion of returns than in large cap indices, which offers greater opportunities for generating alpha.
Market inefficiencies
Many of these stocks are not covered by the large research houses. Consequently, it is easier to find companies that are undervalued. Moreover, M&A transactions are more likely in this market segment (approximately twice as likely as among large caps1).
Main risks
Illiquidity
Small caps usually have a lower trading volume. This means it may be harder to buy or sell shares without significantly affecting the price.
Volatility
They tend to be more volatile in the face of market news or changes in the economy. This volatility means greater risk, but also the possibility of higher returns.
Lower research coverage
The lower level of coverage and the shortage of information not only represents an opportunity; it also makes it difficult to make investment decisions because investors need to conduct exhaustive research themselves before making investment decisions.
What are the differences between startups and SMEs? What are unicorn companies?
Startups are newly created companies that have a scalable business model and rely on technological innovation to maximise their scope for growth. In contrast, SMEs are small or medium-sized enterprises (in terms of revenue or human capital). Unlike startups, SMEs aren't necessarily new.
Unicorns are companies created in the last 10 years that, without being listed or acquired by a third party, achieve a value of at least USD 1bn.
Is now a good time to invest in small caps?
Valuation discount
After underperforming in recent years, small caps are trading at lower multiples and offer a significant discount with respect to large caps. This valuation gap is close to its widest in decades, as small caps are trading around 20% below their historical average1. In addition, small caps are trading at a significant discount compared to their own historical average in most geographies, especially Europe and the USA.
Good momentum
The current context includes reshoring policies and fiscal stimuli that are particularly favourable tosmall caps operating at the domestic level as these policies are designed to strengthen domestic production and reduce dependence on international supply chains.
In addition, according to a survey by William Blair, small companies tend to outperform large companies after periods of economic recession.
Index concentration
The current concentration of large cap indices remains a challenge because it means that the indices are increasingly limited not only to certain companies, but also to certain sectors and factors. According to June data for the S&P 500, market concentration is at a 50-year peak as the six main stocks represent more than 30% of the index's capitalization1. Particularly at this time, investing in small caps offers a significant opportunity for diversification in both absolute (2000 companies in the Russell 2000, where the top 10 represent only 3.62%) and relative (0% overlap with the S&P 500) terms.
Active management in this segment is important as the quality small caps indices has deteriorated significantly, since a significant number of companies in these indices are not profitable. Currently, more than 40% of the Russell 2000 index and, consequently, of the passive funds and ETFs that track it, consists of companies that are not profitable.
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