Leaping goldfish - from the small bowl to the big one

Understanding small cap

Isn’t it great to discover a neighborhood gem of a restaurant? Maybe it’s a place that’s a little out of the way, and hasn’t been reviewed by a newspaper. Or, it just opened and has a rising star of a chef. By this time next year it will be packed, but for now you have it to yourself. Finding a great small cap stock can be a lot like discovering that hidden restaurant, except the rewards may be financial rather than gustatory.

The current definition of a small market capitalization stock (“small cap”) is a company with a market capitalization of $133 million to $3.86 billion1.  Compared to a large cap company, such as General Electric with a market cap of around $280 billion2 and dozens of business lines, most small caps live in anonymity during their early growth years and often focus on just one or two primary businesses.  While everyone has heard of Apple, Amazon, and Boeing, fewer can name more than a handful of public small cap companies.  Obscurity can have its advantages, especially for skilled investors looking to drive incremental return.

Sell-Side Analyst Coverage
Source: Factset, Russell Calculations, December 31, 2015.
Indexes are unmanaged and cannot be invested directly.

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Anonymity leads to opportunity

In addition to the lack of general public awareness, small caps are also relatively underfollowed by the investment industry, particularly as measured by sell side analyst coverage.  In fact, US small cap stocks have roughly the same level of sell-side analyst coverage as stocks in the emerging markets.  If you look down the market capitalization range even further to “micro cap” stocks3, the coverage is even more sparse and comparable to frontier markets equities.  This means that micro and small cap stocks tend to be less well understood. This typically increases the chances that their stock prices will divert from fair value and, thus, provide an opportunity for skilled investors to exploit.

Aside from anonymity, two other primary factors contribute to the heightened opportunity for skilled investors to add value in the asset class: large breadth of individual companies to pick from and greater price volatility of individual stocks. These attributes of small caps give greater and more frequent opportunities to buy stocks at a discount to their fair value.

What to look for in selecting an active small cap manager

Russell Investments believes investors can benefit from investing actively in US small cap stocks, but how and where investors allocate their capital matters. Since 1976, we’ve been scouring the US small cap universe looking for the best investment managers who do the work that sell-side analysts don’t – diving into the details of each company, talking directly with each CEO and CFO, and developing an informed and independent view of company prospects.  While the value that savvy active managers can provide is appealing, investors should note the potential perils of the asset class, such as higher volatility and lower liquidity.  So, it is important to be picky.

We have long recognized the benefits of investing with early-lifecycle managers4 in capacity-constrained asset classes, such as small caps.  Our research continues to show that early-lifecycle managers tend to generate higher excess returns than their more mature peers.5 This is primarily driven by three factors: motivation, agility and opportunity set.

  • Motivation — Some early-lifecycle managers have frequently left large firms and lucrative salaries to start their own companies. In the early years, generating superior performance is their primary focus, because it’s essential to their survival.
  • Agility — A low asset base enhances the probability of generating superior performance. This provides flexibility to exploit opportunities across the capitalization spectrum and increases the ability to respond swiftly to changing market conditions. Conversely, if a manager is moving around too much money in small cap stocks, they are more likely to cause undue market impact and hurt their own returns.
  • Opportunity set — As a manager's asset level grows, much of the small cap universe becomes uninvestable. For example, if a manager with $2 billion in assets wants to initiate a 2.5% position in a stock, this translates to a $50 million investment. If the stock has a $500 million market cap, this involves buying 10% of the company! Since stocks farther down the capitalization spectrum may experience larger mispricings, managing too much money can reduce a manager’s opportunity set and ability to outperform. Conversely, a larger investable universe can bring more diversification to a manager’s portfolio, which helps balance the potential risks and rewards of their other holdings.

Investors who follow the typical industry practice of waiting for a three-to-five-year track record are often too late. Russell Investments’ US small cap team prefers to invest while motivation is high, assets are low, and a manager's primary focus is generating strong returns for investors.

The small cap restaurant is open – maybe it’s time to explore the menu

At Russell Investments, our research has found that US small cap offers one of the highest return opportunities of any asset class.   This makes it an important allocation in multi-asset portfolios. The lack of information, broad opportunity set, and rapidly evolving small cap market offer the exact conditions where, if selected and monitored appropriately, talented active managers can thrive.

1This is the range in the 2016 FTSE Russell reconstitution of the small cap oriented Russell 2000® Index.
2As of June 15, 2016.
3The current definition of a micro cap stock is a company with a market capitalization of $30 to $863 million as defined by the 2016 FTSE Russell reconstitution of the Russell Microcap® Index.
4“The Evolution of the Investment Process” (Paul Greenwood, 1999); “The Perils of Success” (Jon Christopherson, Zhuanxin Ding, Paul Greenwood, 2001); “Start small, stay small: Making the most of U.S. small cap equities” (Jon Eggins, Damien Amato, 2013)
5Of course, not all early-lifecycle managers excel in the first few years. Furthermore, mature managers who conservatively manage capacity can continue to produce superior excess returns. Russell Investments' manager research process carefully vets the individual merits of each manager. Identifying skill is always the highest priority of Russell's manager research effort, but we are sensitive to the negative impact of higher asset levels.

Disclosures

The information, analyses and opinions set forth herein are intended to serve as general information only and should not be relied upon by any individual or entity as advice or recommendations specific to that individual entity. Anyone using this material should consult with their own attorney, accountant, financial or tax adviser or consultants on whom they rely for investment advice specific to their own circumstances.

This material is not an offer, solicitation or recommendation to purchase any security.

Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns.

Small capitalization (small cap) investments generally involve stocks of companies with a market capitalization based on the Russell 2000® Index. Investments in small cap, micro cap, and companies with capitalization smaller than the Russell 2000® Index are subject to the risks of common stocks, including the risks of investing in securities of large and medium capitalization companies. Investments in smaller capitalization companies may involve greater risks as, generally, the smaller the company size, the greater these risks. In addition, micro capitalization companies and companies with capitalization smaller than the Russell 2000® Index may be newly formed with more limited track records and less publicly available information.

The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000® Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership.

The Russell Microcap Index measures the performance of the microcap segment of the U.S. equity market. It makes up less than 3% of the U.S. equity market. It includes 1000 of the smallest securities in the small-cap Russell 2000® Index based on a combination of their market cap and current index membership and it includes the next 1,000 securities.

Russell Emerging Markets Index: Measures the performance of the investable securities in emerging countries globally. Constructed to provide a comprehensive and unbiased barometer for this market segment and is completely reconstituted annually to accurately reflect the changes in the market over time.

The FTSE Frontier Index Series provides a comprehensive and transparent series of benchmarks for the performance of large, mid and small cap equity securities from eligible Frontier markets in Europe, Americas, Asia-Pacific, Africa and the Middle East.

Investments in emerging or developing markets involve exposure to economic structures that are generally less diverse and mature, and to political systems which can be expected to have less stability than those of more developed countries. Securities may be less liquid and more volatile than US and longer-established non-US markets.

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Frank Russell Company is the owner of the Russell trademarks contained in this material and all trademark rights related to the Russell trademarks, which the members of the Russell Investments group of companies are permitted to use under license from Frank Russell Company. The members of the Russell Investments group of companies are not affiliated in any manner with Frank Russell Company or any entity operating under the "FTSE RUSSELL" brand.

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First Use: July 2016