Small cap companies are typically considered as those with a market capitalisation of maximum 5 billion USD or EUR, even less in some index classifications.

Studies show long-term outperformance of this equity factor, especially during times of strong economic recovery such as the one we are experiencing presently.

Small companies are agile, operating in niche markets where competition is less fierce.

In a maturing bull market, large companies often look for fresh external growth opportunities, including the acquisition of smaller companies at a premium.  

A perfect context for small-caps

We believe that well-diversified stock portfolios should include an exposure to mid- and small-caps. Studies show that small-caps tend to outperform large-caps in the long run.

Some reasons for this lie in the nature of the company itself. Smaller companies are usually less complex, often more innovative, and able to adapt to changes in a flexible way. Many are champions in their field of play, giving them a competitive advantage and pricing power.

Other reasons for the long-term outperformance of small-caps are linked to the structure of capital markets. Companies with a low market capitalisation are often covered by few financial analysts, or none at all, and are typically not eligible for inclusion in the vast majority of index funds/ETFs due to their lower available free float and liquidity.

Harvesting the illiquidity premium: consequently, active managers have a good chance of finding hidden gems for their portfolios in this market cap category. In addition, the lower liquidity in small- and medium-cap stocks allow patient buy-and-hold investors to earn a liquidity premium, as highlighted by Ibbotson and Chen (2007) in their paper Liquidity as an investment style.

Why invest now?

Small and mid-caps have a high sensitivity to economic growth. Economic recovery is set to continue into 2022 and the negative effects from supply chain disruptions are expected to fade. Hence, we see a favourable environment for small companies in the USA and even more so in Europe, as the recovery in this region is lagging in comparison. This equity factor is more heavily exposed to cyclical sectors: Industrials, Financials, Consumer Discretionary, Materials, and Energy together represent more than 55% of the MSCI World Small Cap Index versus only 43% of the MSCI World Index.

Two longer trends should support smaller companies. The transition towards a low carbon economy together with the ramp-up in digitalisation require huge investment. Industrial and basic resources companies as well as highly innovative technology companies should benefit from this trend. In addition, rebuilding supply chains and near-shoring production should unlock large amounts of investment in the coming years. Last but not least, we expect a surge in merger and acquisition (M&A) activity. Larger companies tend to acquire smaller companies as a way of gaining access to their technology and innovations. This enables them to pay a premium on the current stock price of the targeted company, one which is captured by the small-cap investor.

Favoured regions and investment ideas

• Regions in focus: USA, Europe and Nordic countries
• Risks: slowdown in economic growth, further supply chain disruptions, central bank tightening
• How to invest:
• Fixed Income: Private debt funds for exposure to higher yielding unrated corporate debt in typically smaller companies
• Other non-public equity: growth Private Equity funds, LBO Private Equity funds
• Equity: US/European/UK/Asian small/mid-cap exposure (SMIDs) via funds and ETFs

Which regions to focus on?

As mentioned above, US small- and mid-caps trade at attractive levels compared with large-caps. We expect a continued economic recovery in the US, so smaller American companies should offer a decent beta to this recovery.

In Europe, small caps are dearer than mid- and large-caps. On the other hand, the cyclical momentum should be more supportive for smaller-caps, as the recovery is less mature in the Old Continent. A weaker dollar could be an additional tailwind. Finally, we should not forget the heavy additional investment that should result from (any) changes in fiscal policy.

We like small caps in Nordic countries because they are the European “powerhouse” of digital innovation. As the digital transformation is well underway and capital expenditure (Capex) is picking up on a larger scale, Nordic small-caps offer good exposure to both these themes.

Risks and how to invest?

What are the risks?

If supply chain disruptions persist or central banks overtighten monetary policy, then small-cap companies would inevitably suffer. Due to their low liquidity and high growth sensitivity compared with large-caps,  drawdowns are typically greater in the small-cap space.

How to invest?

As mentioned above, the small- and mid-cap universe is under-researched. In consequence, active fund managers can generate outperformance if they do their “homework” properly.

Non-listed companies offer attractive opportunities. Private Equity gives investors access to non-quoted, earlier-stage growth companies, whether start-ups or companies that choose not to be listed, but boast a strong product portfolio.

In the current context, we should not forget Private Debt. Small companies shy away from the costs of credit ratings and bond issuance. An alternative is to tap the private debt market for funding. We believe that this market offers attractive premiums in the form of smaller unrated borrowers with healthy balance sheets and cash flows.