Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 8

If the small cap fits, wear it


In Cuffelinks Edition 4, Chris Cuffe’s article mentioned that over long time periods, companies with small market capitalisation (‘small caps’) have outperformed large caps. The pioneering academic work most often cited is from Fama and French in the United States, and their work has been further developed by Elroy Dimson and colleagues from the London Business School, who provide these return metrics looking back since the 1920’s:


We should note however that this phenomenon has diverged in recent times in Australia. The following chart for the last decade shows that at various times both small and large caps have had their times in the sun.

The dominant factor in relative performance is the market’s appetite for risk. In the mid 2000’s bull market, appetite for risk saw small caps surge and outperform sharply until about 2008. Since the GFC, the insatiable investor appetite for defensive yields has seen larger companies do well. It should also be noted that the small resources stocks which represent around 40% of the small cap index have been on a slide for the last two years, dragging the averages down in Australia, something not so much relevant when looking at offshore small cap outperformance.

Why small caps traditionally outperform

Smaller companies in Australia are defined as stocks outside the ASX100 Index. The Small Ordinaries Accumulation Index is what most small cap managers focus on which represents around 7% of the Australian market’s capitalisation. These companies are generally higher growth businesses in their infancy looking to become the next big household name in Australia. A large portion of the top 100 companies in Australia are in the mature phase of their life cycle, and growth rates of 5% are commonplace. These types of returns would be considered measly in the smaller end of town. As investors, we generally find that earnings growth has the highest correlation to share price movements overtime. This partly explains why small caps have outperformed large caps over such a long time period.

Smaller companies are under-researched, which creates the opportunity. Fund managers and stockbrokers scour this part of the market far less than with large companies. Over time, smaller companies that succeed become more noticed by analysts. When fund managers and the market ‘discover the stock’ this creates natural buying and pushes the price and rating up. This can be a good point to take profits given this point of the stock’s rerating generally comes with an expansion of its price to earnings ratio, a dangerous indicator to watch for.

A key part of small cap investing is having access to the senior management of the company. This is critical in understanding the dynamics of the business and what makes the leaders of the business tick. On the other hand, it’s incredibly hard for the majority of investors to contact Ian Narev, the CEO of the largest bank in Australia, Commonwealth Bank.

As an aside, a piece of advice which rings true when interrogating a company’s CEO is would you be happy to introduce that executive as your parent. As an investor in that company you are giving your money to the CEO to manage on your behalf.

The ideal small cap investment would have the following characteristics:

  • strong free cash flow
  • net cash on the balance sheet
  • strong management team
  • strong industry position
  • low price to earnings ratio
  • earnings growth at 1.5-2x price to earnings ratio
  • a catalyst or event that will rerate the share price
  • no other fund managers on the share register

One other advantage of small cap investing is the higher propensity for merger and acquisition activity. A few examples of this in recent years are Count Financial (acquired by CBA), Crane Group (acquired by Fletcher Building) and conglomerate Alesco (acquired by Dulux Group). Smaller companies are more likely to have targets on their backs. If successful, they attract the attention of their larger listed peers who are looking to generate earnings per share growth via acquisitions, when organic growth in their existing business can be anaemic. This can be a boon for investors providing excellent returns in the right circumstances.

Small cap prices are more volatile

Small caps are more volatile and less liquid in trading and are generally higher risk investments. They usually have more focused business lines compared with their larger counterparts, and therefore have a less diversified revenue stream.

The higher risk can be seen when things go wrong with the business, such as profit downgrades or a structural change in the industry. Recent examples of this include the ‘old media’ businesses such as Fairfax and APN News and Media. These companies have been too slow to adapt to the new digital age and have experienced rapid declines in their share prices when compared to the overall market’s return. Negative news flow in small caps generally creates a much higher level of volatility. An earnings downgrade from a company can see a stock fall in excess of 20% when the equivalent for a larger company may see a 5-10% move. This impact generally holds true on the upside with positive news. Higher risk, higher reward.

Large cap investments can provide a more steady return in the form of fully franked dividends. Generally these mature businesses are expected to pay back to shareholders each year a portion of their earnings. A smaller company which is going through a growth phase can require ongoing capital investment. Investors are generally happy for a smaller company to retain capital and invest given the superior return it can potentially generate. As companies grow and become more mature, they can then be expected to provide more income growth. Capital growth on the other hand is generally higher in small caps given the increased propensity to provide larger earnings growth.

Overall small caps have provided a higher return over the long term compared with their larger peers. While they come with added risk, they are an important part of a portfolio allocation decision and selecting the correct small cap investments can provide many happy returns over time.


Chris Stott is Chief Investment Officer and Portfolio Manager at Wilson Asset Management.




Leave a Comment:



Australian large caps outperform small caps over long term

6 checks on whether acquisitions create value

Five actions to watch in management share buying


Most viewed in recent weeks

10 little-known pension traps prove the value of advice

Most people entering retirement do not see a financial adviser, mainly due to cost. It's a major problem because there are small mistakes a retiree can make which are expensive and avoidable if a few tips were known.

Check eligibility for the Commonwealth Seniors Health Card

Eligibility for the Commonwealth Seniors Health Card has no asset test and a relatively high income test. It's worth checking eligibility and the benefits of qualifying to save on the cost of medications.

Hamish Douglass on why the movie hasn’t ended yet

The focus is on Magellan for its investment performance and departure of the CEO, but Douglass says the pandemic, inflation, rising rates and Middle East tensions have not played out. Vindication is always long term.

Start the year right with the 2022 Retiree Checklist

This is our annual checklist of what retirees need to be aware of in 2022. It is a long list of 25 items and not everything will apply to your situation. Run your eye over the benefits and entitlements.

At 98-years-old, Charlie Munger still delivers the one-liners

The Warren Buffett/Charlie Munger partnership is the stuff of legends, but even Charlie admits it is coming to an end ("I'm nearly dead"). He is one of the few people in investing prepared to say what he thinks.

Should I pay off the mortgage or top up my superannuation?

Depending on personal circumstances, it may be time to rethink the bias to paying down housing debt over wealth accumulation in super. Do the sums and ask these four questions to plan for your future.

Latest Updates

Investment strategies

Three ways index investing masks extra risk

There are thousands of different indexes, and they are not all diversified and broadly-based. Watch for concentration risk in sectors and companies, and know the underlying assets in case liquidity is needed.

Investment strategies

Will 2022 be the year for quality companies?

It is easy to feel like an investing genius over the last 10 years, with most asset classes making wonderful gains. But if there's a setback, companies like Reece, ARB, Cochlear, REA Group and CSL will recover best.


2022 outlook: buy a raincoat but don't put it on yet

In the 11th year of a bull market, near the end of the cycle, some type of correction is likely. Underneath is solid, healthy and underpinned by strong earnings growth, but there's less room for mistakes.


Time to give up on gold?

In 2021, the gold price failed to sustain its strong rise since 2018, although it recovered after early losses. But where does gold sit in a world of inflation, rising rates and a competitor like Bitcoin?

Investment strategies

Global leaders reveal surprises of 2021, challenges for 2022

In a sentence or two, global experts across many fields are asked to summarise the biggest surprise of 2021, and enduring challenges into 2022. It's a short and sweet view of the changes we are all facing.


2021 was a standout year for stockmarket listings

In 2021, sharemarket gains supported record levels of capital raisings and IPOs in Australia. The range of deals listed here shows the maturity of the local market in providing equity capital.


Let 'er rip: how high can debt-to-GDP ratios soar?

Governments and investors have been complacent about the build up of debt, but at some level, a ceiling exists. Are we near yet? Trouble is brewing, especially in the eurozone and emerging countries.



© 2022 Morningstar, Inc. All rights reserved.

The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.