The small-cap risk myth

17 November 2014 - Doug Lawson of Amati Global Investors discusses the small-cap risk myth.

It always surprises me how little focus is given to small caps as a major component of investors’ portfolios.  Perhaps the lack of exposure to small caps interests me because most of my own capital is tied up in the small business of which I am a part-owner (Amati Global Investors) as well as the small-cap funds that I help to manage. 

I expect you will be questioning my judgement in exposing almost all of my wealth to a portfolio where success is dependent upon the fortunes of smaller companies, either directly (through my fund holdings) or indirectly (through the business whose success rests on the success of these funds).  But here is my defence: I am 38 years old.  No spring chicken, I agree, and I face the usual day-to-day pressures of many of my age in financing a family, which includes three small children.  I will also have to dip into the pot for certain life events – such contingency amounts will be kept in cash or relatively low risk assets.  But any ‘leftovers’ that I manage to put aside for the retirement pot are likely to remain unmolested for a long time – decades in my case.  And these leftovers will be invested entirely in small caps.  

This is not a short-term market call.  Besides portfolio monitoring and very limited shorter-term ‘tactical’ asset allocation, my ‘strategic’ asset allocation, which most would describe as ‘massively overweight small caps’, will not change.  I don’t obsess over short or even medium-term performance.  My only question is whether I believe, over a 10-year-plus period, that small caps will outperform large caps.  As a guide to this, we can refer to the excellent Numis Smaller Companies Index (NSCI) Annual Review 2014, written by Professors Elroy Dimson and Paul Marsh of the London Business School.  This report examines the returns from the bottom tenth by value of all UK equities listed on the main market.  From 1955 (the inception of the NSCI) to 2013, the NSCI has returned 15.5% per year on a total return basis.  This is 3.5% per annum above the All-Share.  Even over the past decade, which has encompassed one of the most severe market collapses in history, the NSCI returned on average 12.5%, which is 3.7% above the All-Share.  This is a stark illustration of the superior long-term returns from small caps.

But what about the additional risk one takes on in using this strategy?  Firstly, I would point to further data from the NSCI Annual Review 2014, which puts the standard deviation (volatility) of the NSCI at 25.4% versus 22.8% for the All-Share.  This translates into a higher Sharpe Ratio (a measure of how much return is being generated for each unit of risk) over the past 58 years for the NSCI versus the All-Share.  The higher the Sharpe Ratio, the better the risk-adjusted performance.  If you are still sceptical, let me try some anecdotal examples.  Looking at companies that are suitable for our new AIM IHT portfolio, I have been seeking non-cyclical businesses, which stand out as having a long track record of generating good unleveraged returns on capital, possess strong balance sheets, turn the vast majority of profits into cash, and can support a progressive dividend.  In short, I am looking for stability, but without sacrificing some of the growth for which small caps are revered.  Screening for these characteristics delivers companies like Nichols (the owner of Vimto), which has been around for over 100 years, has a strong balance sheet, and well covered dividends.  You then have newer companies like EMIS, which has software embedded in over half the GP surgeries in England & Wales.  Are these revenues at risk?  With 8,500 individual customers accustomed to using this software, I think it is very unlikely.  Then there are bigger, well capitalised consumer brands with big estates, such as Prezzo and Goals Soccer Centres, which have demonstrated their ability to grow throughout an economic cycle.  Thousands of people recognise these brands and will continue to buy them based on their strength.  Or what about CVS, one of the largest veterinary practices in the UK?  Will vets go out of business?  If you don't think so, then why not buy one of the biggest in the country.  Then you look at large caps, where the perception is that you sacrifice growth for stability and a well covered dividend.  I appreciate that I am cherry picking here but Tesco, BP, RBS, Lloyds and a host of resource stocks have recently provided too many exceptions that disprove this rule.

My point is that, whilst the small-cap market as a whole may be more volatile than the FTSE 100, I believe you can pick a portfolio of stocks which reduces this volatility significantly.  In doing this, however, you need to be able to live with the liquidity risk, which is not captured by the volatility measure.  If your investment horizon is long term, the liquidity risk becomes of less significance.  If history is a guide, the pay off for this is higher growth and better returns, even on a risk-adjusted basis.  Given this, I hope it has become understandable why those of us actively involved in this end of the stock market prefer it to large-cap index trackers and their ilk, and are willing to back this view with a significant proportion of our long-term savings.

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested. Doug's views are his own and do not constitute financial advice.
Published on 17/11/2014