The case against investing in Small Caps
People say that small caps are a good investment option. "You can make more money, faster" - so they say.
Small Caps are smaller companies listed on the ASX. Whilst many of them are household names, like Domino's Pizza and NIB, they are much smaller than the majors like BHP and CBA. Conceptually, smaller businesses have more room to grow compared to the juggernauts. This means higher profit growth and higher share price growth. More money for you!
Key to Small Cap investing is the idea that it is easier to find undervalued stocks. This is because Small Cap stocks have fewer analysts and financial experts following them. This means more opportunities for a gem to slip through the crack, waiting for you to uncover them.
The research around how Fund Managers perform compare to the Index support this argument. Australian Fund Managers generally do NOT beat the stock market after fees.
In fact, Australian Small Caps is the only category of stock market investment where professional Fund Managers consistently beat the market. In the last 5 years, 81% of Small Cap Fund Managers beat the market. For the broader Australia market (represented by the S&P/ASX 200 Index) only 22% of Fund Managers beat the market. Only 14% of Australian Bond Fund Managers beat the market.
In the land of Small Caps, it seems to make sense to invest with Fund Managers rather than follow the index.
Does this mean you should find a Small Cap Fund Manager and transfer them some cash?
Hang on ... Not so fast.
The first question to answer is whether it makes sense to invest in Small Caps at all.
Small Caps would be a compelling investment if they provide better returns than the broader share market. Looking at the last 10 years, there is no evidence that Small Caps provide better returns.
The index that tracks Small Caps - the S&P/ASX Small Ordinaries, was beaten by the S&P/ASX 200 Index by a whopping 38% in the past 10 years.
If you invested $10,000 in the Small Cap Index in May 2005, that would be worth $13,472 by June 2015. If you invested $10,000 in the ASX 200 Index over the same period, your money would be worth $21,574.
But wait, I hear you say. Small Cap Fund Managers consistently beat the Small Cap Index. So investing through Small Cap Fund Managers will provide better returns.
Yes and no. Individual Small Cap stocks are generally riskier than larger companies. To justify investing in Small Caps through a Fund Manager, you should seek returns that are higher than the broader stock market.
According to S&P's, only the top 25% of Small Cap Fund Managers beat the broader market in the past 5 years. The ASX 200 provided 6.8% return p.a. The top 25% of Small Cap Fund Managers provided 10.0% return p.a., beating the broader market.
However, the Top 50% of Small Cap Fund Managers only returned 6.2% p.a. When averaging across all Small Cap Fund Managers, they achieved -2.0% return p.a.
If you do want to invest in Small Caps, it would only make sense if you can find a Small Cap Fund Manager in the top 25% of their peer group.
Whilst iShares, Vanguard and SPDR all have an Australian Small Cap ETF, they don't seem to be very compelling. When the Small Cap Index is 38% worse off than the ASX 200, it is hard to favour Small Caps.