9th June 2023
There has been much chatter in recent weeks regarding the extreme narrowness of the US equity market, where YTD gains of 11.9% at the Index level (MSCI USA, local currency) have been driven by just a handful of Mega Cap tech stocks such as Apple, Microsoft, Nvidia, Meta and a few others deemed by investors to be the key beneficiaries of generative AI driven growth. In contrast, the equally weighted (as opposed to market cap weighted) Index of US equities have actually delivered negative returns with history suggesting that performance divergence on this scale is a rare beast indeed. The fact that the Mega Cap names that have led the market higher started the year trading on already heady valuations makes the situation even more confounding, whilst the intense and increasing concentration of the US market poses its own issues. The talking heads and financial pages have already offered plenty on this fascinating, and perhaps worrying pattern of performance, and it is not the intention of this note to add to those column inches. The phenomenon is however indicative of a more persistent, yet equally unusual trend, that has dominated equity markets in recent years. Namely the Large Cap outperformance of Small Caps.
Indeed, since the summer of 2018 MSCI World Large Cap has outperformed MSCI World Small Cap by around 30% whilst the outperformance of large US companies versus their smaller domestic brethren has been even more pronounced. Looking over the fullness of time, this is not a normal situation with Global Small Caps over the past two decades delivering annualised returns that are some 2.7% ahead of Large Caps. The attractions of smaller companies are well understood offering the potential for faster earnings growth as well as a broader, more dynamic and less efficient investment universe from which to select stocks. The Global Small Cap Index for example, has around 6,500 constituents (versus 1,500 for large / mega) including plenty of market leading businesses operating in niche sectors. Low and diminishing analyst coverage in the Small Cap space also means that pricing anomalies are more common and that return dispersion tends to be greater, creating a vibrant hunting ground for Alpha Managers to go truffle hunting. These attributes and the long-term empirical evidence are, of course, recognised in the original Fama-French stock pricing model which highlights the ‘size effect’ as one of three key explanatory factors behind stock outperformance.
Whilst not wanting to wade into what is an often-polarising debate, we suggest that recent patterns of Large Cap outperformance have perhaps contributed to the diminishing number of active managers that have delivered outperformance and, as a result, intensified the conversation around active versus passive. It is worth pointing out however, that most active managers tend to be overweight Mid and Small Caps, largely for the multiple reasons discussed in the paragraph above. When indices are concentrated, and markets are led by a small number of Mega Caps (stocks that are often hard to overweight given their significant size in the index) active managers face a brisk headwind in trying to generate alpha. There will always be good and poor active managers, but our contention is that these alpha seekers have not become collectively worse overnight, and we similarly don’t think that certain equity markets are more suited to a passive approach than others. For the cost-conscious equity investor there is a place for both active and passive, but we wouldn’t mind betting that as and when Mid and Small Caps reassert their historic market leadership, active managers will overall start faring better relative to benchmarks.
When that rotation in leadership occurs is impossible to predict, but the recent underperformance of smaller companies has created a compelling set up from a valuation perspective, with Global Small Caps trading on their largest discount to the Broad Global Index (MSCI ACWI Small Cap versus MSCI ACWI) in over a decade. Generally speaking, we would not regard ourselves as being in the ‘Elephants don’t gallop’ camp and we are typically very happy backing skilled, active managers at the helm of appropriately sized Multi Cap funds which include exposure to larger companies. Reflective of the current opportunity however, the Hawksmoor Funds at present have material exposure to smaller companies via dedicated Small Cap specialists, as well as all Cap Managers who run with a structural bias to the smaller end of the market. Size and AUM is always front and centre for us when selecting funds. This is particularly important when operating in less liquid markets. Our exposure to smaller companies predominantly relies on small and nimble open-ended funds or closed-ended investment trusts both of which are able to exploit their liquidity advantage in terms of building and exiting positions, allowing to quickly shift portfolio exposure when necessary and managing flows (not a concern for investment trusts, of course).
The prevailing attractions of the opportunity in smaller companies is perhaps best brought to life by way of an example. The venerable Small Cap value investor Aberforth Partners has been managing money in the space for over 30 years, with their flagship UK Smaller Companies fund only being cheaper than today on two other occasions. These were the Covid Pandemic of 2020 and the Great Financial Crisis of 2008. The UK Small Cap universe on their numbers currently trades on a 24% discount to the Large Caps which is significantly wider than the long-term average. Capturing the value in Mid and Small Cap companies does not mean either having to embrace lots of cyclicality or balance sheet risk. Gresham House UK Multi Cap Income which has a heavy SMID bias but also a quality growth focussed process trades today on a rare discount to the broader market despite boasting superior growth, balance sheet and profitability metrics. If public market investors are unwilling to recognise the value that abounds within Small Caps, then private equity buyers sitting on mountains of dry powder will, and we are already starting to see a marked increase in M&A executed at significant premiums. Small Cap opportunities abound elsewhere as well, including Japan and the US, and this is where our exposure to those markets is predominantly focussed.
Ultimately, history suggests that small is beautiful most of the time. After a period of persistent underperformance and with valuations at historically compelling levels, we think that is particularly true today.
Ben Mackie – Fund Manager
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