H1 Smaller Companies' Outlook
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Executive summary
Over the last century small caps have outperformed their larger peers by 2.1% p.a. in the U.S. and 3.2% p.a. in the in the UK.
- Since 2011 small caps have underperformed by -1.3% p.a. with a recent significant deterioration.
- We show that all the outperformance of the All-Country World Index (ACWI) over the ACWI Small Cap since 2019 can be attributed to the current top ten constituents which include the Magnificent Seven. The outperformance of the current top ten has driven index concentration to levels not seen since the dot-com bubble.
- This period was followed by a particularly strong period of smaller company outperformance.
- As measured by relative price to sales the ACWI index is at its most expensive relative to ACWI Small Cap since 2003. We believe these factors presage a period of relative strength in smaller companies.
Commentary
The Global Investment Returns Yearbook (henceforth refereed as Yearbook) by Elroy Dimson, Paul Marsh and Mike Staunton is a tour de force in clear articulation of complex return data and meta-analysis of its drivers.
In figure 1 (shown below) we reference a chart showing the long-run cumulative performance of stocks in different size bands in the US and UK. From 1926 to 2023 U.S. small-caps outperformed larger-caps by 2.1% p.a., compounding to a huge 9.7x difference in terminal value. The outperformance of smaller companies was even more dramatic in the UK.
Figure 1 – Long-run cumulative performance of US stocks in different size bands
However, the Yearbook also shows that while the small cap premium persists, there are prolonged periods when it is substantially diminished. In figure 2 we show that over the last 25.5 years MSCI ACWI Small Cap has outperformed MSCI ACWI by 2.3% p.a. on a total return basis which is broadly consistent with the long-term data for the U.S. and UK markets. Figure 2 demonstrates is that is has been a game of two halves with small cap underperforming by -1.3% p.a. since 2011 and -3.3% p.a. since 2019. What has driven this outperformance, and will it continue?
Figure 2 – The relative annual performance of MSCI ACWI Small Cap vs MSCI ACWI
Regarding the first part of the question, over the five and a half years to 28 June 2024, MSCI ACWI has delivered a total return of 99.2% in USD. This has easily surpassed MSCI ACWI Small Cap’s 63.6%, by 35.6%. The top ten stocks in the ACWI (Apple, NVIDIA, Microsoft, Amazon.com, Meta Platforms, Alphabet, Eli Lilly, TSMC, Broadcom and Novo Nordisk) now account for 22.9%, up from an average of 12.5% over the last 12 years.
Figure 3 – Gross index return (%), weight in index (%)
In 2023, concentration in the MSCI ACWI Index reached its highest level since 1999.
Figure 3 shows the current level of concentration in the top ten has now surpassed the 21% reached at the height of the dot-com bubble in 2000. The subsequent period saw a diminished contribution from the top ten, and a decline in concentration. As seen in figure 2, this coincided with a 16-year period, 2000 to 2016, that saw relatively robust performance for MSCI ACWI Small Cap, a period over which small caps outperformed in 75% of the time. What figure 3 also shows is that the top ten concentration is a result of exceptional performance. We estimate the top ten as of 28 June 2024 has returned a simple average of 706% and have accounted for 35.2% of ACWI’s total return, the vast majority of ACWI’s outperformance of ACWI Small Cap.
Turning to the second part of the question, will it continue? We anticipate many of these businesses will continue to develop in a favourable manner, innovating at scale, entrenching their market positions, while driving substantial growth. So much so, we invest in five of them in the Heriot Global Fund. However, price is what you pay, value is what you get, and fundamental progress is not always commensurate with shareholder returns. These ten companies now represent $18.5 trillion in total market capitalization as 28 June 2024, a considerable proportion of global gross domestic product which the World Bank estimated at $97.5 trillion for 2021. If the returns of the past five and a half years are prologue and the top ten again return 706%, their total market cap would exceed $130 trillion, and global GDP. These businesses have changed the world, and they can continue to do so, but will the consume the world and their equity markets? While this is highly unlikely, their quality and fundamentals are not reminiscent of previous periods of high concentration such as the dot-com bubble. As such, it is perfectly possible they continue to outperform, just to a lesser extent.
Figure 4 shows the Price to Sales ratio of the MSCI World, MSCI World Small Cap and the ratio of the two from 29 December 2000 to 28 June 2024. I have used the Price to Sales ratio to control for earnings adjustments and margin volatility, but other ratios are just as valid. The Price to Sales ratio of the World index (in orange) has been on a steady upward trend while the World Small Cap index (in white) has barely moved since 2013. The result is that on this measure, the World index is at its most expensive relative to the World Small Cap index since 2003. The gold line in figure 4 shows the ratio of the two Price to Sales ratios and stands at 2.2x, around the same level as the previous high in index concentration shown in figure 3. Today, it is 38% higher than the 23-year average of 1.6x.
Figure 4 – MSCI World P/S, MSCI World Small Cap P/S, Ratio of the two
If we are at or nearing the zenith of “top ten exceptionalism” what does this mean for investors? Again, turning to the Yearbook Dimson, Marsh and Staunton conclude their section on smaller companies by observing the variability but persistence of the premium and that “…we can see no case for underweighting smaller companies.” Stock selection is our forte not asset allocation. Offering MSCI’s definition of smaller companies as the bottom 15% of global market capitalization establishes the “neutral” allocation.
Closing of this valuation gap, a decline in index concentration and the relative outperformance of smaller companies would be consistent with history. There is a plethora of catalysts for this including an inflection in interest rates, earnings of the Magnificent Seven failing to meet high expectations, and the gradual reallocation of capital to relative value. To echo Dimson, Marsh and Staunton’s conclusion we can see no case for underweighting smaller companies and can see a compelling case to be overweight.
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