Smaller companies: Understanding the Risks
What are the higher risks that explain the small-cap premium? And what characteristics explain why smaller companies perform differently from their larger peers?
Risk and return are two sides of the same coin. Academic studies have tried to identify the higher risks involved in investing in smaller companies. These help explain why investors should demand a higher return. Less noticed are the risks that are lower for smaller companies than larger. Investors also need to understand the risks that are neither greater nor smaller, but simply different. These provide a source of diversification. Finally, investors cannot ignore the risk factors that are common to all companies, large and small.
A smaller company can have a lower market value for two reasons:
- it is relatively risky; or
- it is small (which investors can measure in a number of ways).
Why does higher risk translate to a lower market cap? Investors should apply a higher discount rate to future cash flows of more risky companies. A higher discount rate means a lower valuation. In other words, for two companies with the same annual sales, the more risky company will have the smaller market capitalization.
Does Size Really Matter? by Professor Jonathan Berk looks at the performance of smaller companies classified by factors other than market capitalization, such as annual sales.1 Using these other measures, he found that returns were unrelated to size. The relative riskiness of smaller companies is the dominant factor in explaining the observed relationship between market value and returns. Understanding these risks is key to understanding the value of the company.
In general, academics explain the small-cap premium as the reward for accepting the poor performance of smaller companies during periods of market stress. Active investors must decide if they are being adequately rewarded for this risk. Or they can decide to control these risks, for example by tilting portfolios towards higher quality companies
An investment in a smaller-companies index is higher risk than the equivalent larger companies index. But investing in a smaller-companies portfolio does not have to be.
In summary, an investment in a smaller companies index is higher risk than the equivalent larger companies index. But investing in a smaller companies portfolio does not have to be.
1. Illiquidity risk
The shares of smaller companies are less liquid. They also have higher insider ownership, leaving a smaller free-float for external shareholders. This risk can be mitigated in a portfolio context. However, it translates into a higher cost for entering and exiting positions.
2. Recession risk
Smaller companies have historically underperformed from the peak of an economic cycle to its trough. For the US equity market, this underperformance was 5% on average during the five recessions that have occurred since 1980.2 A longer view captures the Great Depression (1929-1933) and the deep recession of the 1970s (1973-1975).3 These were periods of significant pain for holders of smaller companies.
Chart: US Small-cap relative performance and US recessions, 1926 - 2017
Source: Professors Dimson, Marsh, Staunton and Evans, London Business School, CRSP, Morningstar, NBER, December 31, 2017
This analysis is based on perfect hindsight of when recessions began and ended. In practice, there is a long lag between the start of a recession and its identification. We associate recessions with bear markets. But here, too, investors require hindsight to identify the start of a bear market. Nor do economic downturns and market downturns neatly coincide. This helps explain the somewhat counterintuitive findings of a Numis study:4 UK smaller companies outperformed in bear markets but underperformed in recoveries.
Chart: When do small caps do well?
Smaller companies relative performance in different market and economic regimes
Source: Scott Evans and Paul Marsh, Numis, December 31, 2017
3. Credit risk
The cost of borrowing is higher for smaller companies.5 (Indeed the cost of equity is higher too. Lower average valuations for share buyers translate into higher cost for the companies issuing those shares.) This is consistent with the underperformance of smaller company shares when times are tough: during recessions. The small-cap premium has been higher when rates are low than when they are high. And higher when interest rates are falling than when they are rising.
4. Inflation risk
Equity market valuations are typically higher when inflation is close to target. They are lower in periods when inflation is high, or when inflation falls close to zero or turns negative (deflation). This pattern is exaggerated for smaller companies. This means the small-cap premium is higher when inflation is close to target but lower during periods of low or high inflation.4
5 . Price volatility
The risks above translate into higher volatility of returns for an index of smaller companies than their larger peers.
Big companies are complex organizations. Sony grew rapidly in the second half of the 20th century on the back of sales of Trinitron TVs and the Walkman. By the 1990s, the company had become a bloated behemoth, employing 160,000 people.6 With profits under pressure, the company divided into smaller units, asking each to focus on their own profitability. In 1999, one unit launched the company’s first portable digital player at a trade fair in Las Vegas. Next on stage was a rival product – from a competing Sony unit. Not surprisingly, consumers were confused and both failed. The complexity of large companies makes it harder for management to be in control.
7. Index concentration
The composition of market indices reflects past success. Sometimes one theme dominates the market, leading to a concentration of stocks at the top of the list. At the end of 2017, five US technology companies headed the MSCI World Index: Apple, Microsoft, Alphabet (which owns Google), Amazon and Facebook. Together they represented a combined 7.5% of the index.7
This concentration increases in regional portfolios and is yet more pronounced in single-country portfolios. For example, Samsung Electronics represented 28% of the MSCI Korea Index.8 A few large stocks can skew the overall performance of market-cap weighted equity portfolios.
8. Currency exposure
Smaller companies have a higher proportion of domestic sales, while larger companies include more multinationals. For example, domestic sales accounted for 63% of total sales for companies in the MSCI US Index. This compared to 78% of sales for companies in the MSCI US Smaller Companies Index.9 This means small and large companies have different responses to currency moves.
9. Stock-specific risk
Stock-specific risks are a more significant driver of performance for smaller companies than their larger peers. By contrast, larger companies are more sensitive to other factors such as country, sector and style.
Chart: Stock specific risk as percentage of total risk
Source: Axioma, December 31, 2018
10. Different companies
A portfolio of smaller companies is a different set of companies than a portfolio of larger companies. This might seem too banal to mention. Yet, investment in factor-driven (or smart beta) portfolios is growing, and the same stocks appear in more than one factor sub-portfolio. For example, 55 of the 151 companies in the iShares Edge MSCI USA Value Factor ETF were also included in the iShares Edge MSCI USA Size Factor ETF.10 This overlap is illustrated in the Venn diagrams below.
Chart: Index overlap: number of stocks
Source: MSCI, iShares, December 31, 2018
11. Long-cycle performance
These different risks help explain why capturing the small-cap premium involves periods of outperformance and underperformance. The cycle between small-cap and large-cap leadership differs across different countries. These cycles can last for a number of years.
12. Traditional risk measures
Portfolio managers still need to take account of country, sector and industry exposures. They need to understand their exposure to style factors, such as quality, momentum and value. And, in particular, they need to be aware of stock-specific risks. These are best understood through fundamental analysis.
In conclusion, investors must understand the complex set of risks associated with smaller companies. But it is this understanding that provides the opportunity for active managers to deliver performance.
1 Jonathan B. Berk (Sept/Oct 1997), Does Size Really Matter?, Financial Analysts Journal
2 E. Lecubarri et al., J.P.Morgan, 09/12/2017, The Case for SMid.
3 Professors Dimson, Marsh, Staunton and Evans, London Business School, CRSP, Morningstar (2018)
4 Scott Evans, Paul Marsh, Elroy Dimson (2019) Numis Smaller Companies Index 2019 Annual Review
5 Aberdeen Standard Investments, Bloomberg, 01/31/2018.
6 Gillian Tett (2015), The Silo Effect.
7 MSCI World Index factsheet, 02/2018
8 MSCI Korea Index factsheet, 02/2018
9 Worldscope/Factset (2018)
10 iShares (2018)
Diversification does not ensure a profit or protect against a loss in a declining market.
Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.
Equity stocks of small and mid-cap companies carry greater risk, and more volatility than equity stocks of larger, more established companies.
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