Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 215

The investment bias against small companies

Since the financial crisis, the risk/return relationship that underpins the accepted investment wisdom in Australian equities has been challenged. The funds of median smaller company managers are showing lower levels of volatility and price falls in market pullbacks.

This article considers several explanations for the lower risk across smaller company managers and whether we could expect this to continue.

Risk and return of large and small cap median managers

To analyse the different risk/return characteristics of broad cap (ie the entire market) and small cap (ie smaller companies) managers, we have used the monthly median Australian fund manager returns since 1990. Managers are split using the Morningstar classifications of broad cap or small cap from all the available retail funds in the Morningstar database. Using point in time monthly data removes survivorship bias, and all returns are recorded after fees.

Figure 1 below charts the risk/return characteristics of the broad cap manager compared to the small cap manager over multiple time periods. Over longer time periods (10-20 years), the traditional risk/return theory holds. However, over the shorter time period (5 years) the median small cap manager has experienced superior return at lower levels of risk.

Figure 1: Risk and return characteristics of Australian equity funds

Source: Morningstar, Fidante Partners

Have the risks in larger companies changed?

Whilst volatility should retreat after the generational losses seen in 2007-2009, the volatility of larger company manager portfolios has not reduced at the same pace as smaller company manager portfolios.

Economic sensitivity is generally considered to be higher in smaller companies. This is a reason why these stocks will at times underperform when economic conditions deteriorate. However, analysts may be underestimating the impact on the large end of the Australian stock market from low economic growth due to the sector concentration and the increasing use of new ETF structures that are impacting how large-cap equities are held and traded.

Large companies need economic growth

The long-term growth potential of the stock market is dependent on the level of nominal gross domestic product (GDP). With consumption growth weakened, investments curtailed and the government attempting fiscal prudence, growth has been restrained.

Larger companies especially will more likely proxy and mimic the growth of the broader economy. Larger companies have collectively benefitted on the one hand from falling interest rates and benign cost inflation, however, these benefits are symptoms of a lacklustre growth environment. As proxies for the domestic economy, the aggregate of the larger company market has struggled to achieve strong real organic growth.

For smaller companies, the problem of growth is a different one. Growth rates are more commonly defined by the operational and strategic success of the business. That is not to say that many smaller companies have themselves not had their own challenges, but there generally is more organic growth potential.

Figure 2: Australian GDP

The smaller company market is structurally diversified

Australian funds management is dominated by a handful of bank financials and resource names comprising over 50% of the S&P/ASX300 index. Whilst an active manager can produce a well-diversified portfolio in Australian larger companies, it necessitates the manager hold a very different looking portfolio to the index.

The concept of index concentration in smaller companies is less, if non-existent, without the stock concentration and sector concentration, as shown in Figure 3. An obvious point maybe, but the smaller company universe has a pressure valve, where concentration risk is reduced as stocks move up and out of the index. Whilst a bubble may have its origins in the smaller company universe, it is likely in the large-cap index where the bubble will take hold and do the most damage.

Figure 3: Composition of Australian broad cap and small cap market indexes as at 30 June 2017

In addition, as investors use of ETFs, thematic factor buckets and other pseudo market proxy strategies increase, a lot of stock trading is largely unrelated to the condition of the underlying instruments. The holding period for many stocks is now measured in days and weeks, which is inconsistent with real investing. Liquidity requirements of ETF structures and the belief in the market proxy disproportionally affects larger companies. 

Role in portfolio construction

The analysis of risk-adjusted returns (as measured by the Sharpe Ratio, which is approximately return divided by risk as measured by volatility) of blended small and broad cap median managers shows over the last 20 years, the most efficient portfolio is one which includes 100% smaller companies. This is a theoretical exercise and in practice behavioural biases and preferences of an individual will dictate if an investor can tolerate increased volatility. However, the chart below shows it is possible to incrementally allocate to small caps (below 50%) without meaningfully increasing the overall risk of a blended portfolio.

Figure 4: Portfolio construction: Blending large and small company managers

Source: Morningstar, Fidante Partners

For example, in Figure 4, the blue triangle with the lowest risk and return is 100% allocation to large companies. The blue square is 50% large and 50% small companies, with a significantly larger increase in returns than risk, and hence an increase in the Sharpe Ratio.

Over the last 20 years, whilst little has changed in the smaller company market, a lot has changed in the larger company market. The combination of low economic growth, sectoral concentration and the size of the transient short-term trading may require the investor to carefully consider their exposure to smaller companies versus larger companies.

 

Tim Koroknay is an Investment Specialist at Fidante Partners. Fidante is a multi-boutique asset manager which includes two small companies fund managers, NovaPort Capital and Lennox Capital Partners. Fidante is a sponsor of Cuffelinks. This article is general information and does not consider the circumstances of any individual.

RELATED ARTICLES

Why caution is needed in Aussie small companies

A game plan for managing volatility in global equities

What’s the outlook for global small companies?

banner

Most viewed in recent weeks

Have the rules of retirement investing changed?

In retirement, we still want to reduce stock volatility while generating cash flows. The two needs have not changed, but the reward expected in the old days from interest payments has gone. What should we do?

18 Aussie names for your watchlist

A Morningstar stock screener reveals a cross-section of companies with competitive advantages that are trading at material discounts to estimated value. This is a list of 18 highly-rated names worth watching.

Buffett and his warning about 'virtually certain' earnings

While many investors are happy to invest in any online companies, Warren Buffett focusses more on the quality of future growth, buying companies whose earnings are 'virtually certain' in 10 or 20 years from now.

Hamish Douglass on what really matters

Questions on the stock market/economy disconnect, how to focus long term, technology's growing role, income in a low-rate world, Modern Monetary Theory and endless debt and the tooth fairy.

Kate Howitt: investing lessons and avoiding the PIPO trade

Kate Howitt identifies the stocks she likes and the disappointments, gives context to the increasing role of retail investors, and explains why the market is more of a 'voting not weighing' machine than ever before.

Welcome to Firstlinks Edition 379

It is trite and obvious to say the future is uncertain, and while COVID-19 brings extra risks, markets are always unpredictable. However, investing conditions are now more difficult than ever, mainly because the defensive options for portfolios produce little income. We explore whether investing rules have changed with new input from Howard Marks.

  • 15 October 2020

Latest Updates

Weekly Editorial

Welcome to Firstlinks Edition 381

There is a popular belief that retail investors do not even achieve index returns due to poor timing of investing and selling decisions. The theory is that they buy after markets rise as confidence grows, then sell in panic when markets fall, and miss the recovery. This 'buy high sell low' tendency loses the advantages of long-term investing and riding out the selloffs. But the evidence for this belief is not convincing.

  • 29 October 2020
Investment strategies

Gemma Dale: three ways 'retail' is not the dumb money

There is a popular view that retail investors panic when markets fall, but in the recent COVID selloff, they were waiting in cash for buying opportunities. What's equally interesting is the stocks they bought.

Investment strategies

Unlucky for some: 13 investment risks to check

Risk isn’t something to be avoided altogether. To achieve returns beyond the government bond rate, some level of risk must be accepted. Assessing which risks to take and calibrating them is the investor's challenge.

Responsible investing

Four reasons ESG investing continues to grow

Although Australian investors are among the most ESG-aware in the world, with the vast majority wanting responsible and ethical investments, there are still some misconceptions to dispel.

Shares

Why caution is needed in Aussie small companies

Over the last 20 years, smaller Australian listed companies have outperformed larger companies but with greater volatility. Following a strong run in the last six months, the smaller end is looking expensive.

Financial planning

The value of financial advice amid rise of retail investors

Financial advice has moved well beyond simply recommending investments, with five major components to quality advice. Helping clients avoid potentially disastrous mistakes is often underestimated.

Economy

The 2020 US presidential elections

The US is days away from a presidential election with major repercussions for economic policy and investments in the US and the world. Views from First Sentier Investors and BNP Paribas Asset Management.

SMSF strategies

Can your SMSF buy a retirement home for you now?

It sounds appealing to acquire a property now through your SMSF with the hope of residing in the property once you retire, but there are issues and costs to check that may vary by state.

Sponsors

Alliances

© 2020 Morningstar, Inc. All rights reserved.

Disclaimer
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 class service prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, has been prepared by without reference to your objectives, financial situation or needs. Refer to our Financial Services Guide (FSG) for more information. 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.