Monday, January 20th, 2014

Accentuate The Positive

In the US, small caps have outperformed large caps by 8% over the last 52 weeks; and we have had an overweight recommendation since the middle of June 2013. However the momentum of the outperformance and the scale of our overweight position have both been significantly reduced since late October. When we compare this with Europe, we find that the outperformance is significantly higher (18%) and that our overweight position is (a) larger and (b) still rising.

The obvious explanation is that the economic recovery and the stock market cycle are less mature in this region, but underneath there is a more interesting point. Since inception our US model has had an average overweight of 8% in small caps (part of the small cap effect which we discuss below) compared with only 2% in Europe. The US has a higher average overweight but a lower current overweight. In Europe it is the other way around. This means that the cyclically-adjusted overweight of small caps is larger in Europe than it is in the US.

And so we come to the Small Cap Effect itself – the topic of endless academic papers, which have tried to understand the reasons for the persistence and pervasiveness of this phenomenon. It is widely agreed that the total return from small caps in most developed and emerging markets is consistently higher than large caps and that the gap is more than can be explained by the extra risk. The gap can always analysed in terms of earnings growth and relative valuation, but the problem with these number-crunching exercises is that they are very dependent on periodicity. Results vary depending on the length of the period and the initial condition. Any attempt to quantify a general explanation quickly gets bogged down in data disputes.

We think the answer lies in something we call this the resolution process – the way in which companies and their investors address major strategic or funding problems. To put it crudely, small caps which make a strategic mistake or have a funding shortfall tend to get taken over. Large caps with similar issues sell non-core assets and/or have an emergency share issue. Many analysts agree that control premia play a significant part in explaining the outperformance of small caps, but it’s much harder to measure the destruction of shareholder value in large caps resulting from discounted asset sales and share issues. To our knowledge there has been no systematic attempt to do this.
Large cap restructuring holds the key to small cap outperformance.

If this logic is correct, the much-predicted increase in M&A would obviously be good for the performance of US small caps in 2014. But US large caps have probably written off most of the sins of the previous downturn and sales of non-core assets at distressed prices are less likely than in 2013 or 2012. In Europe it may be too early for a significant increase in small cap takeovers, but we doubt that large caps (especially banks in the periphery of the Eurozone) have finished confessing all their sins. So small cap outperformance in Europe is likely to be greater than in the US, but the reason for this may be a final wave of loss-recognition and restructuring by European large-caps.

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