Do Small Cap Stocks Really Outperform Large Caps Over Time?

It’s a long standing investment truism that small cap stocks deliver stronger returns than large cap companies over time. For most of those investing online this is something that will strike as making sense. Every big company has started out as a small company and making the transition from small cap to large cap necessarily involves valuation multiplying several times. Big companies can’t see that value multiplication because no matter how big they get there is a logical ceiling.

Sure, in theory, Apple can still sell more iPhones. The world is getting slowly richer as the ‘middle class’ of emerging economies grows and then a chunk of that middle class will start to aspire towards an iPhone, right? But Apple already sells a lot of iPhones – 216.76 million over its 2017 fiscal year. Is it realistic to expect the company to sell 300 million iPhones in 2018, 2019 or 2020 at roughly the same price? Almost certainly not.  

Could a new, small competitor with a kind of cool, well priced smartphone getting good reviews sell 1 million units in 2018 and then 2 million in 2019? That’s definitely possible and if it were listed on the stock exchange its value would rocket, multiplying several times. What about a small oil exploration company that suddenly hits a rich find that it can exploit or sell on for a fortune? Of course, its value would also shoot into orbit.

There have been several studies conducted over the years in both academia and by professional investors, looking into the veracity of the ‘small caps deliver higher returns’ truism. However, it is also the case that in comparison to the analysis of other ‘return drivers’ such as value, momentum, quality and volatility, the volume of research into size has been less significant.

Of the studies that have been conducted into company size as a returns driver, there have been varying conclusions. The first well-known research into the question was Rolf Banz’s paper ‘The Relationship Between Return and Market Value of Common Stocks’, published in 1981. His findings, backed up by a few follow-up studies, suggested that over the previous 40 years smaller US-listed companies had delivered better returns than those of big companies.

A recent article for Stockopedia compares Banz’s work to more recent studies such as that of Elroy Dimson, Paul Marsh and Mike Staunton for Credit Suisse’s Global Investment Returns Yearbook 2018. Their research shows that between 1955 and 2017, UK microcaps delivered an average return of 18% a year, small caps 15.4%, mid caps 14% and large caps 12%. Over the same period, US micro caps had an average annual return of 12.7%, small caps 12.2% and large caps 9.9%. However, the research also demonstrated that within the 70-year period there were significant stretches over which the opposite has been true and large caps delivered better returns. A lot, therefore, depends on time lines and divergence isn’t so huge as to mean there isn’t a reasonable chance it could invert over the next 10, 20, 30 or 70 years.

There is also evidence which suggests that the size to returns equation may be to at least some extent correlation rather than causation. A paper titled ‘Fact, Fiction and the Size Effect’ by AQR Capital analysts came to the conclusion that a smaller market cap equalling higher returns over time isn’t a strong trend and is also one that has weakened over the past few decades. However, the research did find that other factors such as value, momentum and quality tend to be stronger across small caps and has helped them outperform larger companies longer term. This is put down to lower liquidity and higher volatility.

The conclusion seems to be that there is some truths to the presumed logic that smaller companies show a stronger return on investment but far less than thought and not by dint of their actual size but other drivers such as quality, value and momentum. This in turn leads to the conclusion that anyone investing online in individual company stocks would be best advised to analyse and judge small caps by the same criteria as large caps and choose companies that show good quality, value and momentum ratios and indicators. More smaller than larger companies may demonstrate those qualities but investment choices should not be made on the basis of size itself.