Should investors hold lots of smaller stocks? It depends upon your time horizon and attitude to risk.
In the long run, it doesn’t matter much, because small caps do about as well as larger ones. Since 1990, total returns on the FTSE small cap index have been much the same as those on the FTSE 100.
Yes, small caps did outperform before the 1980s. But investors wised up to that fact in the 1980s and bought smaller stocks so much as to raise their prices and so bid away their previous under-pricing. Markets do sometimes learn.
In fact, there’s a good reason to expect similar long-term returns on small and large stocks. It’s normalisation law, the idea that growth is independent of size. If smaller companies grew faster than big ones, we’d eventually end up with a market in which all stocks were the same size. And if big ones grew faster, we’d end up with a giant monopoly. Neither outcome has happened over 300 years of capitalism, which is reason to suspect it won’t happen (though not of course proof.)
Over shorter periods, however, small caps can be very attractive. For example, in the last five years they’ve returned 133 per cent, 75 percentage points more than the FTSE 100.
Which poses the question: what determines shorter-term fluctuations in small caps relative to big ones?
One problem we face in answering this is that returns on the FTSE small cap index relative to the FTSE 100 are very volatile. It’s common for returns on small caps to deviate by more than 20 percentage points from FTSE 100 returns over a 12-month period. Anything that’s so volatile will be hard to explain. Because of this, raw correlations between annual relative returns and factors you’d expect to explain such returns are quite low.
If we take such factors together, however, a pattern does emerge. There are a few things that help explain relative returns.
One of these is the All-Share index. Small caps on average outperform the FTSE 100 when the general market does well. Controlling for the other things which we'll come to, a 10 percentage point above-average annual return on the All-Share index is associated with small caps outperforming large ones by 2.7 percentage points.
Valuations also matter. Dividend yields on small caps and the FTSE 100 also predict subsequent annual returns.
Short-term interest rates also matter. High and/or rising rates are bad for small caps.
Another determinant is the 10-year gilt yield. When this rises, small caps do well. Taken with the adverse effect of rising short rates, this implies that a flattening or inversion of the yield curve is bad for small caps, while a steepening is good. This is consistent with small caps being cyclical. normalisation of the yield curve often point to slower growth, and this is worse for small caps than for big ones.
Two other things confirm that small caps are cyclical. One is that they tend to outperform the FTSE 100 when manufacturing grows well, but underperform when it falls. Small caps did badly, for example, in the recessions of 1991 and 2008-09.
The other is that small caps outperform when sterling rises. One reason for this is that FTSE 100 stocks get most of their earnings from overseas, and a stronger pound reduces the sterling value of such earnings. Another reason is that a stronger pound is often a sign of rising confidence in the UK economy, and this benefits small caps more than big ones. When sterling fell after the vote to leave the EU (because investors anticipated slower growth), small caps fell relative to the FTSE 100.
We could use these factors to predict relative returns. I reckon that on consensus assumptions, they point to small caps outperforming the FTSE 100 slightly over the next 12 months. This is because they should benefit from small rises in the All-Share index and in output more than they suffer from a small rise in interest rates, and valuations aren’t sending a strong message either way.
I’d rather, though, use all this as a guide to risk.
The big risk here is not so much that small caps would be hurt by rising interest rates. If rates do rise significantly, it’ll probably be because economic growth justifies a normalization of rates – in which case what small caps lose from rising rates they should gain from rising output.
Instead, the big risk is of recession. Falls in output, sterling and gilt yields – all of which would probably happen in a recession (or if investors fear recession) – are bad for small caps.
In the near term, the threat of recession is probably small. In fact, there’s hope for small caps; they would benefit (in relative terms at least) if, as I suspect is possible, sterling rises.
In the longer-term, though, a recession is inevitable. Any gains you make on small caps are probably just a reward for taking on this risk.
