From 1927 to 2010, small caps outperformed large caps by an average 2.9% per annum, according to the bank.
During bull markets, small caps tend to outperform conventional equities and exposure to small caps instead of a “global equities bucket” provides portfolio diversification that can improve returns, Speciale said.
Small caps tend to be aligned with domestic macro trends, which means a strong argument can be made for investing in them now. In the US, for example, multiple, positive signs of an economic recovery are creating small cap sector opportunities, said Jonathan Piskorowsk, portfolio manger for US small caps strategy, the Boston Company Asset Management.
He cited healthcare, in particular small niche biotech firms, in the energy sector, energy extraction equipment suppliers, as well as opportunities in finance and construction.
In some markets, such as the US, small caps that export could be hit by the rising US dollar.
However, Speciale said the majority of small caps are engaged in domestic business.
“They are often majority owned by founders or individuals who are often closely related to the management of the company.”
Liquidity risk
Small cap risks include lack of liquidity. Small companies have little or no coverage from analysts and the financial press, Speciale said. With less awareness than analyst-covered equities, small caps tend to be traded less, which results in liquidity issues.
However, there is an upside, he said. Because the small companies are under the radar, local investment teams on the ground can find overlooked gems.
Volatility is also a concern. Small companies have sensitive balance sheets with little room for error. They cannot absorb shocks as easily as large caps.
“Although it’s more volatile asset class than global equities, the excess return as a percentage increase is much larger than the incremental risk as a percentage increase,” Speciale said.
“That means you improve the Sharpe ratio. You add a little more risk but you’re being rewarded for that risk because of a high incremental return.”
In Europe, for example, in 11 out of 15 calendar years, small caps had a better Sharpe ratio than large caps, added Jurgen Heinz, head of European small caps, Meriten Investment Management.
Japan’s hidden value
In Japan, small caps have been on a tear the last three years. The small cap index has outperformed the S&P 500, the US small cap index and the broader Japan index.
Japan’s macroeocnomic transition – from lengthy GDP contraction to expansion – is providing an opportunity to invest in small caps, which are practically unknown even though they are listed entities, said Miyuki Kashima, head of Japanese equity investment at BNY Mellon.
“After two decades of stagnation, Japan’s economy and stock market are at an early stage of a long term growth recovery phase.”
When Japan’s stock market rebounded in the past, it was always due to global reasons, such as the global tech bubble, or in the few years preceeding the Lehman-sparked crisis.
“This was the first time, in 2013, when Japan’s stock market alone went up 50% due to a Japan-specific reason. It looked like [the country] is coming to the end of a long deflationary period.”
The average earnings per share has recovered to pre-financial crisis levels but the market has not, she said.
She particularly likes the services sector, real estate and construction. The Japanese yen is expected to continue to depreciate, so Kashima said her team will also look at export-oriented small caps.
“The market should be 35%-40% higher. Small caps are [an ideal] entry point because they tend to outperform in a rising market.”
