SMALL CAPS, BIG OPPORTUNITY

When it comes to investing, small can be beautiful.

As the Nobel Prize-winning economist Eugene Fama has demonstrated, small-cap stocks consistently outperform large caps over the long term. Indeed, since 1926, US small caps have outperformed large caps by nearly 2.4% on an average annual basis.

However, there are nevertheless significant risks associated with investing in listed small companies.

The greatest risk is volatility: especially during periods of economic downturn, small caps frequently underperform large caps. Indeed, the shorter the investment period, the greater the likelihood of volatility in small-cap indices.

This isn’t surprising when you consider the basic characteristics of small and medium-sized enterprises (SMEs), typically defined as firms with under 250 employees and an annual turnover of less than €50 million.

SMEs are typically quite dependent on a single domestic market. Changing market conditions – even on a very local level – can therefore have an outsized impact on an SME. Market movements can likewise shake up small caps, which tend to be thinly traded and more vulnerable to both micro- and macroeconomic shocks.
 
By their nature, small caps are also almost always in the investment and growth phase, a risky period for any business and an especially challenging one for a small firm that may sometimes find accessing capital difficult.

For similar reasons, the lack of significant analyst coverage on small caps is a common barrier to attracting investment. Indeed, this is an issue that typically predates IPO – as a small business leader struggles to tell a convincing equity story to a skeptical investment community.

Even though nearly every blue-chip began life as an SME, investing in any single small business can be a gamble. But the equation changes when that investment is made not in one small business but in an entire class of them … over a long period of time.

This is what Fama was thinking about when he coined the term “small-cap effect.” Simply put, no other asset class has created as much value over time.

That’s why we remain enthusiastic about the investment outlook for small caps. Another reason for our confidence comes from the bright prospects for this asset class in the next two years. Over that horizon, growth in earnings per share for small caps is expected to be much higher than for large caps.

This kind of growth potential and value creation is possible because of visionary entrepreneurs whose focus on innovation drives growth, and who typically foster a very strong corporate culture, often in a niche where competition is at least initially limited.

Frequently family businesses, SMEs are often managed across multiple generations, providing stability. Given this multi-generational structure, SMEs are typically risk averse. Further, when and if they list, owner-operators often hold a large percentage of shares in their own company – which is usually supportive of long-term growth ambitions.

Germany is a strong example of an SME culture that has long provided a competitive advantage. Independent, family-owned businesses make up the core of the Mittelstand, the backbone of Europe’s largest economy. Key success factors there include niche positioning and a special focus on innovation.

SMEs also have significant growth potential in France, where the government is increasing public financing for small businesses and enhancing regulations to support their growth. In particular, the state’s recently launched Equity Savings Plan (Plan d'épargne en actions, PEA-PME) should increase their ability to access capital.

Under this scheme, individuals may invest up to €75,000 in European companies – including both listed and private firms – with fewer than 5,000 employees and a maximum annual turnover of €1.5 billion or a total balance sheet of less than €2 billion. If that investment is held for a minimum five years, any capital gains are untaxed.

The introduction of PEA-PME savings accounts could generate up to €2.5 billion in additional annual liquidity for SMEs, according to estimates. That could translate into much-needed job creation in a country where the unemployment rate has stagnated at roughly 10%.

In the meantime, small business managers must demonstrate their ability to adapt to the greatest threat facing any company: change.

Addressing this point, the management theorist Peter Drucker insisted upon an important distinction between a business that happens to be small and one that is truly entrepreneurial. “The entrepreneur always searches for change,” Drucker said. “He responds to change and exploits it as an opportunity.”


Ms. Bounaix is a fund manager at Paris-headquartered KBL Richelieu, a member of KBL European Private Bankers. The statements and views expressed in this document are those of the author as of the date of this article and are subject to change. This article is also of a general nature and does not constitute legal, accounting, tax or investment advice.