Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 73

Why have small cap stocks underperformed?

According to the renowned Elroy Dimson, Emeritus Professor of Finance at the London Business School, the share prices of small companies have consistently outperformed large companies over the longer term. The ‘small-cap premium’, as Dimson describes it, equates to an average of 0.54% per month across global equities over the long term. In the United States the premium is 0.72% per month and in Australia, it accounts for 0.52% of outperformance per month, one of the highest premiums of the markets compared. However, over the last two years small caps have underperformed their large cap rivals in Australia. So why have our small company share prices bucked the historical trend?

Measuring up

Since mid-2012, the S&P/ASX All Ordinaries Accumulation Index, which represents the 500 largest companies listed on the Australian Securities Exchange (ASX), has risen a remarkable 47.0% as the current bull market has charged ahead. Over the same period, the S&P/ASX Small Ordinaries Accumulation Index, which tracks the performance of the ASX’s small-cap companies (outside the top 100), has increased just 11.7%. The contrast between the two indexes is stark and particularly incongruous when you compare the two indexes over the preceding three years. Between March 2009 and June 2012 the Small Ordinaries Index outperformed the All Ordinaries by 9.6%.

Is the 35.0% outperformance by large companies over small companies in the last couple of years reflective of a structural change or is it a mere short term variance? In our view, the last two years in the Australian equities market represents a short term anomaly to the longer term trend. We believe this is the case for two main reasons. Firstly, small mining and mining services companies which dominate the Small Ordinaries Index have significantly underperformed in recent years. Secondly, the All Ordinaries Index  is dominated by the big four banks and Telstra and has relatively outperformed as investors have piled into these stocks in search of yield.

End of the mining boom

The well-documented end of Australia’s recent resources investment boom has hit the mining and mining services sector hard. As China adapts to lower economic growth, the demand for resources has softened and spot commodity prices have fallen, in some cases, significantly. While Australia’s miners were the major beneficiaries of numerous major mining projects announced, through the 2000s, many of these projects are now coming to an end. With Hancock Prospecting’s Roy Hill mine the only major new domestic project currently slated to come on line, the contract pipeline for many of Australia’s mining and mining services companies is now very weak. As a result the valuations and share prices of many of these companies have plummeted with some trading below their prices during the depths of the GFC. Tellingly, the five worst performers over the last two years are mining and mining services companies as shown in the following table.

In 2012, a total of 36% of companies that made up the Small Ordinaries Index were mining or mining services companies. As at 30 June 2014, this figure had dropped to 26%.  Over the last two years, the Small Resources Index which measures the performance of small mining companies alone, shows  they collectively fell 42%. Stripping out the mining companies from the Small Ordinaries Index, the Small Industrials Index reveals the remainder of the small caps performed strongly, rising 32% over the last two years. While mining companies have floundered, we have experienced a recovery in many cyclical industrial stocks such as those in the housing and finance sector.

The hunt for yield

A key market theme over the last couple of years has been investors’ chase for yield as the Baby Boomer generation moves into retirement. While in the past a reasonable income stream could have been derived from term deposits, the current historically low interest rates have driven investors into higher-yielding blue chip stocks. Whereas term deposit yields are averaging around 3.3% per annum, Telstra, for example, is currently paying a grossed-up yield of 7%. With some maturing term deposits previously paying around 6%, the choice between rolling over at around half the yield or investing in Telstra is compelling. And as banks have benefitted from low interest rates and better economic conditions, they have performed strongly.

Australia’s equity market is very narrow with the four major banks and Telstra currently accounting for 32% of the All Ordinaries Index. Their valuations have increased with a disproportionate impact on the equity market resulting in them being responsible for approximately two-thirds of the equity market’s performance over the last two years.

Small cap performance to return to long term trend

The key to small caps turning around will be the improvement in mining stocks. If commodity prices rise and investor sentiment towards mining stocks improves, this will necessarily improve their valuations. Already there has been an improvement in sentiment which has led to a rise in the sector’s share prices of approximately 15% off their recent lows.

We expect that current low interest rates could drive economic growth which would in turn lead to an uptick in small cap earnings. In our view, the small cap sector will again outperform the large caps reflecting Dimson’s findings over the longer term, and the recent underperformance by the small cap sector is a cyclical, rather than a structural change.

 

Chris Stott is Chief Investment Officer at Wilson Asset Management. His views are general in nature and readers should seek their own professional advice before making any financial decisions.

 


 

Leave a Comment:

RELATED ARTICLES

Small caps are compelling but not for the reasons you might think...

Two proven ways to make big money in markets

Three ASX small caps set to shine in 2024

banner

Most viewed in recent weeks

2024/25 super thresholds – key changes and implications

The ATO has released all the superannuation rates and thresholds that will apply from 1 July 2024. Here's what’s changing and what’s not, and some key considerations and opportunities in the lead up to 30 June and beyond.

The greatest investor you’ve never heard of

Jim Simons has achieved breathtaking returns of 62% p.a. over 33 years, a track record like no other, yet he remains little known to the public. Here’s how he’s done it, and the lessons that can be applied to our own investing.

Five months on from cancer diagnosis

Life has radically shifted with my brain cancer, and I don’t know if it will ever be the same again. After decades of writing and a dozen years with Firstlinks, I still want to contribute, but exactly how and when I do that is unclear.

Is Australia ready for its population growth over the next decade?

Australia will have 3.7 million more people in a decade's time, though the growth won't be evenly distributed. Over 85s will see the fastest growth, while the number of younger people will barely rise. 

Welcome to Firstlinks Edition 552 with weekend update

Being rich is having a high-paying job and accumulating fancy houses and cars, while being wealthy is owning assets that provide passive income, as well as freedom and flexibility. Knowing the difference can reframe your life.

  • 21 March 2024

Why LICs may be close to bottoming

Investor disgust, consolidation, de-listings, price discounts, activist investors entering - it’s what typically happens at business cycle troughs, and it’s happening to LICs now. That may present a potential opportunity.

Latest Updates

Shares

20 US stocks to buy and hold forever

Recently, I compiled a list of ASX stocks that you could buy and hold forever. Here’s a follow-up list of US stocks that you could own indefinitely, including well-known names like Microsoft, as well as lesser-known gems.

The public servants demanding $3m super tax exemption

The $3 million super tax will capture retired, and soon to retire, public servants and politicians who are members of defined benefit superannuation schemes. Lobbying efforts for exemptions to the tax are intensifying.

Property

Baby Boomer housing needs

Baby boomers will account for a third of population growth between 2024 and 2029, making this generation the biggest age-related growth sector over this period. They will shape the housing market with their unique preferences.

SMSF strategies

Meg on SMSFs: When the first member of a couple dies

The surviving spouse has a lot to think about when a member of an SMSF dies. While it pays to understand the options quickly, often they’re best served by moving a little more slowly before making final decisions.

Shares

Small caps are compelling but not for the reasons you might think...

Your author prematurely advocated investing in small caps almost 12 months ago. Since then, the investment landscape has changed, and there are even more reasons to believe small caps are likely to outperform going forward.

Taxation

The mixed fortunes of tax reform in Australia, part 2

Since Federation, reforms to our tax system have proven difficult. Yet they're too important to leave in the too-hard basket, and here's a look at the key ingredients that make a tax reform exercise work, or not.

Investment strategies

8 ways that AI will impact how we invest

AI is affecting ever expanding fields of human activity, and the way we invest is no exception. Here's how investors, advisors and investment managers can better prepare to manage the opportunities and risks that come with AI.

Sponsors

Alliances

© 2024 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. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. 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.