Standard Life Investments

Through the Lens

The Smaller Company Paradox

  • Evidencing the small-cap paradox
  • Why big doesn’t always mean better or mitigate risk
  • Finding the information gap through via a robust investment process

The first 10 years of the millennium were frequently described as a ‘lost decade’ for equities. Global stock markets have generally strengthened since then; however, the long-term returns from large-cap and small-cap equities have diverged starkly. Between 1 January 2000 and 31 December 2014, global large-cap equities returned 81.1% compared to a return of 332.2% for smaller companies*. This is known as the ‘smaller company paradox’.

Size matters

Investing in smaller companies certainly entails additional considerations, such as liquidity, risk and the sheer scale of the universe. Although smaller companies are often less complex than their larger counterparts, there is undoubtedly less research available on them. This can open up an information gap and present opportunities to find compelling investment ideas, placing a premium on a workable and reliable investment process.

Since the millennium some of the largest companies have either imploded or declined in value, indicating that size and scale do not necessarily mitigate risk, as investors in Royal Bank of Scotland, BP or Nokia are all too aware. Consequently, the risk differential between large and small-cap companies may not be as great as many perceive. Our analysis of risk-adjusted returns over the period 1 January 2000 to the end of December 2014 illustrates that on a global basis (with the exception of Asia Pacific ex Japan) smaller company returns outstrip those of their larger peers. This confirms that the smaller company paradox does exist and exposure to small-caps could be a significant source of alpha generation in a portfolio.

smaller company paradox chart

Focusing on the fundamentals

Our long-standing smaller company investment process emphasises predictability, visibility, quality and stability, alongside positive earnings and business momentum. We focus on key corporate attributes that are proven lead indicators of share price performance. Meetings with management are also essential for gauging future growth opportunities or equally, the potential for risk.

Recently, our research in European smaller companies led us to invest in Irish property company Hibernia. The business invests in Irish commercial real estate assets, predominantly in the Dublin central business district. At present, 91% of existing income stems from the Dublin office market, with average rent of €34 per square foot.

In addition, the business will deliver development projects in the South Docks area. We toured several of the sites recently, which confirmed that demand remains strong from the likes of Google, Facebook and Twitter as well as financial services companies. Supply remains tight (vacancy levels are circa 4%) and despite strong rental growth there remains only modest new capacity, with the developments by Hibernia the first to come on-stream in 2017. In our opinion, strong demand and limited new supply will be key drivers of rental growth over the coming years, with rents of €60 per square foot possible.

We believe that smaller companies offer significant investment attractions. However, the size and breadth of investment opportunities present major challenges for all but the most skilled and well-resourced managers. A well-defined and consistent process for exploiting the returns is a must for those who wish to outperform over the longer term.