In Australia, small caps seem to have displayed that controversial notion of the ‘small cap effect’. They have outperformed large caps over most five-year periods since the 1970s. In the US, where data is better, small caps have outperformed large caps over each 20-year period since the early 1900s. David Aylward, managing director at Aussie equity shop Tribeca Investment Partners, ponders the skew in the Australian market. The large-caps sector is where the brokers make most of their money, he says, and where fund managers have most of their allocations, “so a large rump of the market is under-researched, and that leaves pockets of opportunity, those mispricings that the market has not picked. The forecasting error in earnings starts to exponentially blow out at stock number 30, that’s how skewed the market is. We’re looking for the undiscovered gems.” Contrary to this, Peter Sumner, MLC’s Australian equities portfolio manager, says “the common belief that mid- and small-caps can outperform large-caps over time is not necessarily true – the small-cap sector was smashed in the GFC. People think you can add more value to small- and mid-caps, and this is again not necessarily the case.
Risk premium Small cap opportunities have increased since the global financial crisis when big broking firms cut back on their research efforts, according to Rob Feldman, head of global small caps at Pyramis, Fidelity Investments’ non-US institutional brand, says small-cap companies tend to be more local than large caps and certainly have a lot less “sell-side coverage” from the research departments of broking firms. “That creates an opportunity for buy-side researchers,” he says. Small caps have a risk premium attached because they are considered more likely to go broke than large-cap companies. They tend to be less diversified and will often have difficulty raising capital. Their stocks are less liquid and to get in or out for super funds can either take a very long time or cost a lot of money through market impact. So, maybe the premium is justified. On the other hand, he says, small-cap managers seem to be able to outperform their benchmark with ease, at least in Australia. Some Australian super funds benchmark their smallcap managers against their peers first, and the Small Ordinaries benchmark second, as a better way of rewarding skill.