Small Caps Outperform Large Caps

Why do small cap companies outperform large cap companies?

Small companies grow faster

Fundamentally, smaller companies’ profits grow faster than large caps, particularly in periods when credit availability is plentiful, economic growth is accelerating and there are ample undervalued competitors that can be acquired.

When M&A take place at reasonable valuations with the aim of taking synergy benefits, they are share price accretive. High valuations and forays into totally different business lines destroys value. Conversely, small caps tend to underperform when these conditions are reversed. 

Small caps outperformance on fundamentals can also be supported by the presence of complacent large-cap incumbents in an industry undergoing disruption or ecological changes which redefine the framework of competitive advantages for that industry.

85% of BSE 500 companies slide towards mediocrity within five years of achieving greatness. In fact, the average probability of a great company actually becoming a sector laggard 5 years later is 25%.

Owners and managers of small companies are hungry to grow, hungry to achieve greatness and all the other perks which come with it. They tend to be intensely driven and do not have to go through layers of management hierarchy in order to respond to changes in the business environment.

Small-Cap companies get discovered

Small cap companies are neglected by the brokerage houses. Besides coverage by brokerage and analysts, policies around liquidity or size may prevent institutional investors from allocating money to small cap stocks.

Brokerages cannot generate enough revenues from institutional trading commissions on small caps. Lack of such potential revenues diminishes the incentive to provide broad research coverage for small caps creating a lower level of market efficiency.

The drop in the cost of capital helps the small caps disproportionately

Cost of capital in India is higher than that of most emerging markets. Secondly, for smaller businesses, the cost of capital is higher than the Indian norm. Regardless, they borrow from banks or from the bond market. The development of the corporate bond market is also likely to lower the cost of funding especially for smaller companies. 

As the bond market deepens, higher quality smaller companies will increasingly be able to get cheap credit from the bond market than from the banks.

Investors need professional help in identifying high quality small caps

Scope of generating superior long term investment returns is greater with small caps. The need for professional help is also greater. The reason behind it is small companies are riskier than the large ones due to both fundamental as well as non-fundamental reasons. The good news is that the Indian fund Management Community now offers several high quality small cap and Mid Cap funds.

On the fundamental size, smaller companies often stumble in trying to become big. Significant investments in IT systems and processes across functions-such as HR, Information Technology, Data Analytics, supply chain, manufacturing and advertising-are often not needed to run a small company. However, the lack of proactive investments in such systems and processes make it harder for these firms to scale up without running into logistical or financial issues.

The lack of a high quality professional management means that as and when problems arise, many smaller companies often do not have the management bandwidth to deal with them.

Example: TTK Prestige

TTK Prestige, between 1999-2003, went from a position of strength to the brink of bankruptcy. This downfall was due to a combination of labour issues in its manufacturing plant in Bangalore, a recessionary environment in India, stiff competition in its export markets (US), increase in excise duty on pressure cookers from 8 per cent to 16 per cent and the failed launch of a new product leading to inventory write-offs. 

Recollecting this troublesome period, K. Shankaran, Director at TTK Prestige, said in May 2013, ‘The biggest issue we faced was that although we had grown to a decent size, we were still running TTK Prestige as a small company. There was no segregation of responsibilities amongst senior managers and hence, every senior manager was working like a jack of all trades. We had to change that.’

Additionally, TTK had accounting issues, and it is generally seen that smaller companies when compared to larger companies have more accounting issues.

Larger capitalisation firms have better accounting scores on average.

“As a result, whilst the scope for generating superior long-term investment returns is significantly greater with small-caps (relative to large-caps), the need for professional help is disproportionately greater than is the case with large-caps.”

Whilst  BSE 100 has compounded at 16.7% per annum over the past eight years, BSE small cap index has compound at 21.4 % per annum over the same period.