Tuesday, 4 May 2010

"Small is Beautiful" - Also True for Investing

The famous and influential 1973 book Small is Beautiful by E.F. Schumacher (see Wikipedia summary) proposed a philosophy that small is good for economics and business. Though the book did not address investing, the title applies to investing as well. Two decades after the book appeared finance researchers Eugene Fama and Kenneth French published ground-breaking results (what is now called the Fama-French Three-Factor Model) which showed that smaller company stock returns outpaced those of large companies over long periods, though at the cost of higher volatility or risk.

What is a Small Company?
They are companies whose total stock market value or capitalization is at the bottom end - thus the term small cap. It is a relative term, where the dollar limit varies by different stock exchanges, mutual funds, ETFs and search tools. The TSX Small Cap Index sets a range of C$100 million to $1.5 billion in quoted market value. In the USA, one popular index is the S&P SmallCap 600, which sets a range of $250 million to $1.2 billion.

Higher Returns and Volatility of Small Companies
The charts below illustrate this reality using Google Finance charts of prices of US and Canadian ETFs that track the small cap sector.

1) Long Term Outperformance - Since June 2000, the small cap iShares S&P 600 Small Cap 600 Index ETF (symbol: IJR) has gained 87% while the total market iShares Dow Jones U.S. Total Market Index (IYY) has lost 10%.

That return advantage is not typical or sustainable over the very long term. Since the 1920s the excess return of small cap stocks in the USA vs large caps has been about 1.5% per year.

2) Volatility - During the recent financial crisis from mid 2007 onwards, small cap stocks in Canada, as measured by the iShares S&P/TSX Small Cap Index ETF (XCS) dropped significantly more than the overall market tracked by iShares Capped Composite Index ETF (XIC) and they still have not regained the lost ground.

Pros and Cons of Small Companies as Investments
  • potential for faster growth that is often realized - large companies are so big they cannot and do not grow as quickly - thus the higher returns from small caps
  • higher risk of business trouble - the counterpart of faster growth is a higher failure rate for individual companies
  • much less tracking and analysis by professional and institutional investors or the business press, so less information is available about smaller companies. This in turn translates into both higher risk and more opportunity for individual investors to find mis-priced stocks.
  • lesser trading volumes which can mean higher spreads between bid and ask prices and possibly illiquidity, where it is hard to buy or sell
  • relatively uncorrelated with other asset classes, which can bring diversification benefit to a portfolio (for how this works and why it is important, see How to Diversify without "Diworsifying" and Asset Allocation: the Most Important Investment Decision You Will Make)
Ways to Invest in Small Caps
  • ETFs in the USA - For US companies there are several dozen different choices - see the listing of Small Caps in Stock Encyclopedia
  • ETF in Canada - For Canadian small companies there seems to be only one ETF at the moment: iShares S&P/TSX Small Cap Index ETF (XCS). ETFs are typically passive index trackers and simply mimic the market.
  • Mutual Funds - Hundreds of funds are available in Canada, covering both Canadian and US companies. To find them, go to GlobeFund's Fund Selector page then in Option B Asset class pick the US or Canadian Small/Medium. Mutual funds almost always try to outperform the market through active stock selection though only some succeed as the majority do not.
  • Individual companies - Use a stock filter such as the Glove Investor Stock Filter (note that discount brokers such as BMO Investorline also typically have such a tool within their website) to select small cap companies. Simply type in market cap size minimum and maximum limits (e.g. ones noted in the ETFs above) and run the search. The stock filter also allows you to start narrowing the possible investment targets using fundamental factors like net profits, sales growth, debt levels etc. Listing the holdings of ETFs, which are all publicly available on their websites, is also a quick way to find reasonably liquid small companies since the ETFs usually exclude companies with too little stock trading.
Portfolio Allocation: Authors like Richard Ferri in All About Asset Allocation and William Bengen in Conserving Client Portfolios During Retirement recommend that small companies make up 5% to 15% of a total portfolio depending on individual circumstances.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

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