Special Comment: Quality small caps – A bedrock for superior returns

"The gold from the North" was the nickname for amber traded from the North Sea and the Baltic Sea all the way down to Southern Europe and the Middle East. This prized commodity from the North was offered in the Temple of Apollo in Athens and it was even found in the tomb of Tutankhamun.

The ancient strategy of buying cheap in one market and selling high in another was well established as early as 1600 BCE in the Nordics; the Amber Road is one of the oldest trade routes in recorded history. Buying in one market and selling in another is still valid trading strategy.

In this Special Comment, we will look into aspects of small caps investing. We will examine the international historical outperformance of small caps, and why small caps are better suited for active investment strategies, creating fertile ground for excess returns.

The historical outperformance of small caps

Fama and French's seminal work established "Small vs. Big" as a key pillar in their asset pricing model. Eugene Fama later won the Nobel Prize (2013) for his contributions to empirical asset pricing, including his work with Kenneth French on the long-term outperformance of small caps.

As illustrated in the chart below, $100 invested in the US small-cap landscape in 1926 would have returned over $5,000,000 today, compared to only $1,400,000 in the larger cap market.

Critics of Fama and French's work often point to two key elements:

1. The small-firm effect is less pronounced outside of the US when adjusted for volatility and liquidity risk.

2. The effect was less profound post-1981.

However, recent research has shown that while the effect was subdued from 1981 to 2000, it reemerged prominently in the period after 2000, reaffirming the performance potential of small caps. Norges Bank Investment Management has shown that the small cap effect has been a long term positive both in the US and Internationally, with an outperformance in the US as strong as 3% pa.

Size matters if you control for junk

In the small cap markets the quality of the companies varies significantly, thus a highly selective approach is crucial for success. This is very much supported by the study "Size matters, if you control for junk," where Asness et al. point out that when adjusting for a quality factor, the outperformance of small caps is clear and persistent across time, markets and industries.

The quality factors are well represented in the Nordic technology sector, we find. We will dive into the technology and quality angle of our investment strategy in future Special Comments. Anchora plans to support similar academic research in the Nordics to investigate this effect further.

Small attractions

Active small cap managers enjoy certain advantages:

• Management of smaller companies tend to be more accessible for investors compared to their larger brethren.

• There is a greater selection of small caps to choose from: 1,422 out of the 1,622 listed companies in the Nordics have a market capitalization of less than USD 2 billion.

• Smaller companies often go overlooked, with a lesser analyst following.

These conditions may make it easier to identify attractive investment opportunities in the small cap market. Morningstar’s manager research services find that small cap active managers outperform large cap active managers consistently over the long run, and across geographies. Small cap managers are more likely to beat their index than others.

A tilted playing field

Small cap managers are playing a tilted playing field, where the odds are more stacked in their favour than in the large cap segment. And while the jury may still be out with regards to the size effect – is small better than big? – it seems clear that once you control for junk, there is a market anomaly where quality small cap portfolios generate excess returns. Across time, industries and geographies.