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Can small caps stay ahead? - Eureka Report article

Can small caps stay ahead?

By Scott Francis
August 7, 2009

PORTFOLIO POINT: Small caps deserve a place in portfolios, but investors should not judge them on this year's performance alone.

For some time owning small companies has been accepted as a way of increasing the returns from a portfolio. In Australia the "small-company effect" has been considered a strong one, with small companies tending to outperform larger companies by some margin.

Alan Kohler earlier this year (see New, improved investment formula) encouraged Eureka Report subscribers to have some small-company exposure in their portfolios - and it is interesting to see how this strategy faired over this remarkable year to date, in which the Australian stockmarket fell for 10 weeks of the year before staging the current recovery.

A reasonable way to look at the performance of small companies is to use the Standard & Poor's website (LINK), where Australian stockmarket indices are calculated. These indices measure the average return from different sections of the market. In this case, we are interested in the return from the "total returns" indices, which include price movements and dividends received over the period.

More particularly, we are interested in the Small Ordinaries total returns (or the Accumulation index), which looks at the return from the 100th - 300th biggest companies in the Australian sharemarket. We will compare this with the return from the biggest 100, the S&P/ASX 100.

nASX 100 vs Small Ordinaries (total returns), calendar 2009

As the above graph shows, the returns from small companies over the 10 weeks of the year, when markets were still falling, lagged the large company returns by about 2%. Since then, however, the story is different. For the calendar year up until the close of trading on August 4, the return from the Small Ordinaries Index has been twice that of large companies: a 36% return vs an 18% return. Since the March low, the Small Ordinaries has rallied an impressive 62% (from 3080 points to 4980 points) compared to the still-welcome 37% from the ASX 100 (5340 to 7306).

However, the following graph looks at the returns from the Small Ordinaries total return index for 2008 against the ASX 100 total returns index over the same period. It shows that during that extraordinarily difficult period for shares, small companies provided a lower return than large companies. Higher returns from small companies does not seem to be a "free lunch"; clearly, there are periods of significant underperformance that accompany these returns.

nASX 100 vs Small Ordinaries, (total returns calendar 2008)

A key question, then, is whether there is any support for the idea that small companies might outperform large companies? As far back as the early 1980s researchers had identified that small companies seemed to provide a higher return than large companies.

On a theoretical level it is argued that small companies are riskier than large companies, and therefore people are not as willing to pay as much for their shares. This leads to the possibility of higher returns because the shares of a smaller company start at a comparatively lower base than a large company. It is important that investors keep this risk/reward tradeoff in mind so that the risks of investing in small companies are appropriately acknowledged in the trade off for the possibility of higher returns.

It should be noted that the existence of a "size effect" (higher returns for smaller rather than larger companies) is not unanimously accepted, although it seems to remain clearly the more commonly accepted view.

There are many instances of companies that try to sell products such as software packages that provide recommendations for small and micro ASX-listed companies. Often they use "simulated returns" or "hypothetical portfolios" to demonstrate returns. There is good reason to be very sceptical any time "hypothetical" or "simulated" returns are used to promote any product: investment returns are difficult to calculate at the best of times and without the methodology behind the figures it is hard to evaluate the process, particularly with small companies.

The "price effect" occurs because many small companies have very low share prices, which might distort actual performance. For example, consider a share trading at 4¢. Let's assume that on the first day it falls to 3¢ - a 25% fall. The next day it rises back to 4¢, or by 33%. Simply adding the two days' returns (-25% + 33%) leads to the ridiculous conclusion that the share has risen in value by 8%.

Many very small companies in the Australian context trade infrequently, and in very small volumes. Therefore a "simulated" or "hypothetical" portfolio might make the assumption that the shares could be purchased or sold, where the realities of an actual transaction would have been impossible at the assumed value.

There is still general support for the idea that small companies have a higher expected return than large companies, and certainly the strong returns from small companies in the Australian stockmarket over this calendar year provide some support for this thinking. However, these returns are not without risk, as the 2008 calendar year returns show, when large companies outperformed. Overall, the balance of evidence suggests that the allocation of some of your portfolio to small companies is well worth consideration.