When investors begin to hunt for investment opportunities, companies with well-built reputations are usually the first to pop up in their minds as these companies are portrayed as a relatively secure investment. As a result, many smaller sized firms are left unnoticed. Some investors even consider small-cap stocks as purely speculative instruments due to its deceptively cheap price coupled with heightened volatility.

Before: In the local setting, Securities Commission Malaysia (SC) and Bursa Malaysia announced that the stamp duty for companies of market capitalization ranging from RM200 million to RM2 billion as of 31st December 2017 will be waived from 1st of March 2018 till the 28th of February 2021. This was done to boost retail participation while improving liquidity in small-cap stocks. 

After: One way the local government is helping the little guys is by abolishing stamp duty for three years – a type of tax that’s applied to shares trading on the local bourse standing at RM1 per RM1,000 of transaction cost or part thereof, with a maximum charge of RM200. Around a third of listed companies (RM200 million to RM2 billion mid and small-cap firms) have benefited in retail participation and liquidity since March 2018.

 

Introduction

Small-cap stocks are just a term used to classify companies with small market capitalization where its range of “small market capitalization” may differ by nation. Historically, small-cap stocks are known for its outperformance over major indexes.

Several studies have shown that small-sized firms almost consistently achieve abnormal returns over their larger counterparts (Mid-cap and Large-cap) over a long timeframe.

Source: Banz, 1981.

http://www.business.unr.edu/faculty/liuc/files/BADM742/Banz_sizeeffect_1980.pdf

 

Drawbacks

Given that most investors’ primary goal is absolute return, why not just dump the entire portfolio in small-sized firms only? If something seems too good to be true, then it probably is. Always remember there is no free lunch on Wall Street.

Survivorship bias

We travel back in time to World War 2. Introducing Sir Abraham Wald, a mathematician who was a member of the Statistical Research Group (SRG) in the USA. The air force was concerned about reducing aircraft casualties and researched the planes that returned from the warfare. The air force found out that most planes received a high number of ballistic penetrations to the wings and tail whereas the engine was mostly left untouched. The military concluded that the wing and tail are vulnerable to ammunition and require a higher degree of armour protection. Wald disagreed and proposed to increase the armour on the engine. While seemingly counterintuitive, Wald’s took account of survivorship bias among the sample of aircraft casualties as the aircraft that took hits in the wing and tail managed to survive. Survivorship bias is a fallacy of focusing on samples containing only data that have unknowingly passed a certain selection process while potentially excluding those that fail to do so. In the world of investing, we tend to focus on winners while avoiding losers. In various researches involving small-cap stocks, samples like the Russell 2000 Index and S&P Small-cap 600 Index are commonly used. It should be noted that any companies that cease to operate will automatically get excluded from the index and is replaced by another company, resulting in inflated returns in small-cap stocks. It is equally important to be aware of the reversed survivorship bias, which is the exact opposite, where winners are excluded from the sample while losers tend to remain in the sample. Small-cap companies that are winners will eventually move up into mid-cap indexes whereas the losers will remain as small-cap companies, potentially understating the returns of small-cap. It has been generally agreed that the survivorship bias is more prevalent than its counterpart, hence most observed returns over small-cap stocks are usually overstated.

Liquidity

Liquidity is the ability to convert an asset into cash without significant loss in value. Since smaller companies receive less analyst coverage in general, it is only natural for these stocks to be thinly traded by both institutional and retail investors. Illiquid stocks have a wide bid-ask spread, further discouraging market participants to trade the stock.

Volatility

Volatility refers to the degree of variation in prices over time. Small-cap equities also have a notorious reputation for having wild price swings. Investors that prefer consistency or those that cannot stomach a huge drawdown in their portfolio are advised to steer clear of small-caps.

 

Advantages

Despite the mentioned drawbacks of investing in small-cap equities, some factors have been widely agreed on to have contributed to the outperformance in small-cap equities.

Scalability

Scalability refers to the ability to grow in size without compromising profitability. Both small and large companies have their respective advantages over one another. Small companies tend to be more adaptive to changes in business environments and possess concise internal communication whereas large companies have access to cheaper sources of capital and the ability to attain economies of scale. Nonetheless, small companies have the inherent ability to outgrow large companies. Think Microsoft versus any small company, Microsoft has a market cap of approximately 1 trillion dollars as of this date, which is approximately 5% of America’s 2019 GDP. It is more likely that an average small size company can double its market cap within a year compared to Microsoft. For Microsoft to double in size, it would make up approximately 10% of America’s GDP ceteris paribus, which might pose as a structural threat of being too big to fail. Microsoft would have to expand aggressively while frequently acquiring other competitors for it to double in size, which is highly unlikely given the bureaucratic structure of large companies. In other words, almost any small-sized firms with strong fundamentals present a higher chance of abnormal returns due to its ability for unlimited growth.

Institutional trading behaviour

We assume that most huge movements in share prices are caused by institutional volume only. We take an example of a 100-million-dollar fund that invests solely in 20 small-cap stocks where each position will take up an equal weight of 5% in the total portfolio. Assuming Company A has a market cap of 100 million dollars, the fund would have invested 5 million dollars into it. The problem is that this makes the fund a large stakeholder, owning up to 5% of the company’s stock, whereby the fund can influence the business decisions. Traditionally, institutions only invest in stocks which they believe are considered undervalued to profit from the temporary mispricing, not to manage the company or whatsoever. Furthermore, these institution takes time to build their positions in smaller companies due to low liquidity whereby the buying action can cause such drastic short-term upward price movements, increasing their average entry price which is above their ideal entry price. There are also legal restrictions whereby institutional ownership in a company mustn’t exceed a specified cap unless the institution proposes a takeover offer. In other words, institutions generally can invest limited amounts in small-caps to avoid being a huge stakeholder, entering at an inflated average price, or exceeding a designated ownership limit. This, in turn, grants retail investors with capital mobility to buy at attractive prices while gaining a higher exposure towards small-cap equities, potentially granting the opportunity to outperform institutional investors.

Inefficient pricing

As institutions invest only in substantial amounts in small-caps, these companies generally receive less analyst coverage and go under the radar of news headlines. This can lead to share prices exhibiting irrational pricing, potentially being undervalued or overvalued over an extended period. Retail investors can exploit these mispricing by buying undervalued companies and shorting or completely avoiding overvalued companies.

Successful predecessors

Many investors utilize value investing because they have been proven to perform well like Benjamin Graham and Warren Buffett to name a few. If there were to be a father of small-cap investing, it would be no other than Peter Lynch. Peter Lynch is an American investor who is famed for achieving approximately 30% annual return throughout his career in Magellan Fund between 1977 to 1990. His investment strategy was described in his book “One Up on Wall Street”. His primary philosophy is to invest in what you know as the more familiar you are towards a business or industry, the more likely you can spot the next company with huge upsides. Lynch firms believe that the average individual investor can achieve higher average returns than a fund manager because they can spot good investments in their daily lives before Wall Street does. He doesn’t have rigid limitations over his investments where any firm that falls within a favourable expectation will make a justifiable choice. He outlined that he spotted several investment opportunities not in his office but while being out with family or casually shopping. In general, he does have a strong preference for small and fast-growing companies that can be bought at a low end of valuations. Just to name a few, Lynch also finds characteristics like a boring company, low institutional ownership, spin-offs, the availability of share buybacks as an extra advantage.

 

Conclusion

Some debate whether the observed outperformance in small-cap equities will continue in the future. Nevertheless, a rational investor should always conduct adequate research before buying any stocks regardless of its size.

 


Researcher: Cheong Jian Yan

Editor: Gan Chee Hor


Download the article:  The case of Small-cap Equities

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