Why Australia has missed out on the “small cap effect”

The idea that smaller companies offer higher risk-adjusted returns than larger companies, a claimed phenomenon known as the “small cap effect,” continues to live rent-free in the collective mind of Australian investors.

The size effect was first coined in Rolf W. Banz’s seminal 1981 paper “The relationship between return and market value of common stocks.” (1) Banz asserted that smaller firms, which he defined as the smallest 20% of the universe by market capitalisation, have higher risk adjusted returns, on average, than larger firms. Banz also found little difference in returns between medium sized and large sized firms.

But, for an investor, is the concept all it’s cracked up to be? Namely, does Banz’s concept of the small cap effect hold water in the Australian market?

There are currently 2,400 firms listed in the ASX. If an index was to be created on the ASX using Banz’s definition of a small firm, the largest constituent would be roughly A$8m in market capitalisation. In contrast, the smallest company in the ASX small ordinaries index currently is $200m in market capitalisation; and some of the largest constituents are larger than A$10b in market capitalisation. Perhaps unsurprisingly, the experience of an in investor in the ASX small ordinaries index has persistently bore no resemblance to the stellar returns depicted by Banz.

While many investors in Australia take a decision to structurally overweight small cap stocks given the sector and stock concentration in the large cap index, our analysis suggests that a separate allocation to small caps isn’t necessarily the best or most cost effective way to achieve this.

This paper will make the case that the performance, risk and constituent characteristics of the small cap index in Australia are poor; that the small cap designation is itself a misnomer (at least as it pertains to Australia); and the consequent benefit of investing in an unconstrained fund that can play the entire ASX.

Higher volatility, lower returns

Ultimately the decision to own any sub-set of investments must be assessed relative to the broader opportunity set. With small cap Australian equities that opportunity set is clearly the broader index.

The following two charts show the rolling 10 year performance of the small and large cap (S&P/ASX 200) index along with the 10 year annualised volatility of each index.

Put simply, at an index level it simply hasn’t made sense to own the small cap index relative to the large cap index over any reasonable time frame, let alone once we account for the risk of small caps being pretty at least 20% higher than that of large caps since the Global Financial Crisis. The long term “drag” from small caps in Australia relative to large caps has been in the order of 2.2% p.a. since 1992 and 3.7% p.a. over the last 5 years.

Why does the small cap index structurally underperform?

Australian market indices have a unique history, with the Australian Securities Exchange (ASX) setting construction rules around the particular circumstance of the Australian market. Indices were set up to reflect the needs of the local capital markets - in particular for small companies to be able to raise capital. The nature of the local market meant that many of these companies were non-revenue generating mining companies who would raise capital for the purpose of exploration or mine development - and in the absence of a venture capital industry this capital was sought through the listed company stock exchange. So unlike many other markets, the Australian market indices were built around, at times, a large number of non-revenue or profit generating companies – and this methodology was continued after S&P Dow Jones took over the ASX index business in April 2000.

Despite having strict rules in other markets around current profitability and financial viability, when S&P Dow Jones took over the ASX indices (now known as S&P / ASX) there was no change in the index construction process that considered financial viability as a determinant of index inclusion. When looked at through an active small cap equity manager lens, one of the most effective portfolio construction methods was to avoid the losers - which in the Australian market (outside occasional periods of speculative excess) were often embedded in these loss making index constituents. There is no question that given the poor index construction methodology employed in this part of the market, investors should actively manage this exposure.

Don’t small caps offer much greater earnings growth prospects?

Despite evidence abroad to the contrary, the answer for Australia is no. The chart below shows the relative actual earnings growth of small and large cap companies over the 10 years since 1992.

It is clear from the chart that over the last decade large cap earnings have significantly outpaced small cap earnings, albeit within each market there will be areas where we have seen significant earnings growth for a period of time. The assumptions that the small cap effect exists in Australia at an index level as returns have been better and that is a function of better earnings growth is, put simply, false. Again, we would suggest that flexibility here is the key to exploiting the opportunities that can and do arise in small caps from time to time – this means both actively managing the small cap exposure and actively managing the allocation to that exposure.

Think fundamentals, not market cap

Disaggregated, high growth opportunities exist and will continue to exist. And smaller companies undoubtedly exhibit higher degrees of economic diversification.

There is considerably more economic diversity available by venturing into small cap Australian equities and the potential for some very strong growth stories to emerge. However, the generally accepted approach that we should carve out a specific part of our portfolio for dedicated small cap investment, however we might define that, should be subject to the same rational review as any investment opportunity.

While large caps have structurally outperformed, the performance differentials between small and large cap Australian equities have been significant and highly cyclical, representing potential for additional value add.

As such, we would suggest that investors should look at the asset class in aggregate rather than having a structural weight to a subsector of the asset class that has shown significant, consistent underperformance and considerably higher risk.

While this may be implemented in separate allocations, investors should consider a more active approach to the relative weights in large and small caps. Alternatively, the Schroder Equity Opportunities Fund offers unconstrained exposure to the full ASX, basing investment decisions on company fundamentals, operating models and execution rather than index narratives. Reflecting this, the fund’s active share(2) sits at 66.01% as of April 30, 2024.

One notable example of a smaller company which has benefited portfolio returns through the past year is Boral. In late 2022, Vik Bansal was appointed as CEO and Managing Director of Boral (ASX: BLD). In the year that followed, fundamental financial performance changed markedly - revenues up almost 20%, EBITDA up twice that again, and operating cash flow increasing by more than 50%.

What does it mean for asset allocation?

An objective look at the opportunities presented across the small and large cap Australian equities market suggests that segmenting the allocation by market cap (as defined by some arbitrary stock number) isn’t necessarily the best way for investors to manage their portfolio. While investors may wish to consider a bias towards smaller caps to take account of the greater economic diversity from this part of the market, we present a number of reasons why an alternative broad cap exposure is a more rational way to structure a clients’ aggregate Australian equities exposure versus separate small and large cap portfolios.

In particular, we conclude that:

• the small cap index is poorly constructed and suffers from significant structurally lower long term performance, higher risk and poorer earnings growth characteristics;
• active management of this part of any Australian equity exposure is both essential and rewarding;
• the appropriate benchmark against which performance should be measured and fees calculated is a broader market index or the large cap index rather than a specifically small cap index as this is more representative of the opportunity set and removes the bias created by an arbitrary index cut-off;
• the performance differentials between small and large cap stocks, while biased in favour of large cap, have shown significant historical variability and this represents a greater opportunity for investors with broad cap research capabilities to add value.

As such, in our view the choices available to investors that want small cap exposure as well as large cap exposure are:

• invest in two separate strategies (large cap and small cap) and actively manage the allocation between these strategies or;
• invest in a strategy that provides a fund (with the requisite skills) the flexibility to invest across the broader Australian Shares universe (S&P/ASX 300).

We believe that both options have pros and cons and both should be considered by investors looking to get exposure to small companies in their portfolios. At Schroders, we offer a more diversified broad cap approach with a significant exposure to stocks outside of the top 100.

The structure of our unconstrained strategy, the Schroder Equity Opportunities Fund, is premised on our view that relative size as the single determining factor behind the relative attractiveness of a stock has a weak linkage to the economic fundamentals of a business, and the relative investment merits of that company. Our approach is not wedded to either large or small caps but rather takes an active exposure to all capitalisation segments of the market, and not simply the structural bias inherent in, say, a standalone small strategy. As such, using the full breadth of the universe and departing from benchmark weights based upon assessment of investment merit continues to be a potential source of alpha for active investors.

Our unconstrained approach also manifests in the way we structure our team, where stock coverage is allocated to each analyst on a sector basis and extends down the market cap spectrum to include large, mid, small and micro-cap stocks. We believe this integrated approach to research is superior to a market cap based approach as it enables deep industry knowledge to be shared. The overriding factor in dictating stock inclusion and position size is the desire to maximise exposure to high quality businesses at attractive valuations. Avoidance of both poor quality and overvalued businesses should enable returns above those of any size-determined indices (either large or small) over the longer term.

Managed Fund

Schroder Equity Opportunities Fund - WC

Australian Shares

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