As someone who has spent nearly two decades in the world of small caps, overseas and in South Africa, I know that many investors have come to believe that small caps are dead. This time, they say, it is indeed different, and there is no cycle. That investors are witnessing a structural decline in small-cap investing and small-cap returns globally.
However, we must remember Mark Twain’s remark: “Reports of my death have been greatly exaggerated.” The same can be said about small caps.
Over the past decade, small caps have underperformed large caps, and there are many reasons for that. The success of large-cap tech stocks with large consumer-facing businesses has driven investors into these household names. They have been encouraged by brokers and market talking heads quoting investment legend Peter Lynch, to “buy what you know”. Tesla, Amazon, Microsoft and Google are all products we know, and most of us use them daily.
This strategy has worked to date, but the outlook doesn’t look as rosy now, with increasing capex costs for AI and regulatory scrutiny.
We are also seeing the tech giants pushing through significant price increases to maintain margins. A case in point is my own Microsoft 365 subscription, which will increase from R1,099 to R1,599 a year at the next renewal date, according to an e-mail I received just this week. A price hike of 45%. Time to look at cheaper alternatives.
The ubiquitous use of exchange traded funds and index funds to execute low-cost passive investing and portfolios has been a one-way street for 15 years or more, since the global financial crisis (GFC). Index-style products, though, are hard to implement due to liquidity constraints at the small-cap level.
No passive fund flows have found their way into small caps. The mantra from “finfluencers” across the media landscape of buying an S&P 500 index tracker or any large-cap country index of choice has also directed investor capital away from the small-cap market.
The rise of private markets in the post-GFC world has been something to behold. Private equity (PE) and venture capital (VC) have gone from niche and specialist segments of the institutional market to mainstream over the past 15 years. The paradoxical nature of this flood of assets into both PE and VC is best summed up by Marc Andreessen, of Silicon Valley venture capital firm Andreessen Horowitz. He suggests there has never been so much capital and investor patience for small private companies and never so little capital and investor patience for small public companies.
So, what is going to change? While the malaise in small caps has gone on for a significant period in multiple global markets, we are still in a cycle, and the cycle must turn at some point if one believes in investment cycles at any level.
A basic economic theory states that small-cap investments are riskier than large-cap investments over time. So, investors in small caps must be rewarded with additional return for taking on this additional risk, all other things being equal. The long-term risk and return numbers in academia bear out this relationship. Thus, unless this relationship has fundamentally broken down, small caps will have their time in the sun again.
Compared to historical cycles, we are just experiencing an elongated cycle of underperformance of small caps relative to large caps. If you believe small caps are in structural decline based on the recent evidence of stock market returns, you might want to answer the question once posed by Irish economist and politician Garret FitzGerald: “That’s fine in practice, but will it work in theory?”
It is Nobel prize-winning stuff if you can prove why large caps will continue outperforming small caps into the future, despite a lower risk profile for large caps.
The valuation gap between large and small caps has also hit historical extremes in nearly every equity market globally. Again, following economic theory, investors will eventually balk at the extreme multiples of large caps and turn their attention to the lower valuations applied to small caps.
A process of mean reversion will occur. If we want evidence, look at the gold market as an example of how a market can turn. Gordon Brown, former chancellor of the exchequer, famously offloaded just over half of the Bank of England’s gold reserves a little over 25 years ago when gold was trading at near multi-decade low prices against today’s record highs.
Though small caps remain out of favour and the timing of a rebound remains uncertain, it is only a matter of time before we see a sustained turnaround in the fortunes of the small-cap asset class. Now is the ideal time to revisit individual small-cap stocks to position yourself and your portfolio for the turn in the cycle — when we will once again be talking about a bull market in small-cap stocks, as we have done at many other points in history.
Tobin is the founder of Coffee Microcaps
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