Stock prices of small companies outperform large companies over the long-term. However, this is not true in all environments, and buying small company stocks comes with its own risks and costs.

What is market cap?

Let's start out with the UK market looking at small caps versus large caps. Market capitalisation, or market cap, is the total value of all the shares of a company. A small cap is just a small company. For example, Topps Tiles has a total of about 200 million shares. At the time of writing each of those shares was worth 63 pence and 200 million times 63p gives you £124 million. That's the market cap of Topps Tiles.

Topps Tiles is a tiny company when we compare it with a large cap company like Royal Dutch Shell that has almost a billion shares in issue each of which is worth £25. Multiply the two together and the market cap of Shell is over £200 billion, so you can see the massive disparity between the small companies and the large companies which trade on the London Stock Exchange. There's a roughly two-thousand-fold difference between the tiny companies and the huge companies and there's also a fundamental difference between the way the two types of stock trade.

In this diagram companies are ranked from largest at the top to smallest at the bottom by market capitalization. The FTSE 100 contains the largest 100 companies. Then the next 250 largest companies go into the FTSE 250, and we call those mid cap companies. All the rest of the companies from 351 down to about 620 go into the FTSE SmallCap. There's also a FTSE 350 index which is the FTSE 100 and FTSE 250 combined, and the FTSE AllShare which contains everything.

Understanding Liquidity

The fundamental concept that you have to understand when thinking about small caps is called liquidity. Liquidity tells you how easy, fast and cheap it is to buy and sell a company's stocks and if you understand this graph will understand liquidity.

This contains all of the FTSE AllShare stocks which trade on the London Stock Exchange. Small caps are on the left and large caps are on the right and on the y-axis we have high liquidity at the bottom and low liquidity at the top. As a measure of liquidity we've used the difference between the buying price and the selling price of the stock. For the low liquidity stocks this difference is larger which means that they're more expensive to trade. I've colour coded the FTSE 100 in red so those are the large caps at the bottom right and you can see that they have very high liquidity. This is because large cap stocks trade millions of pounds worth of shares every day. Brokers don't have to make such a big markup for large caps because they trade a very large volume of shares every day.

The FTSE 250 which is made up of mid caps, is in green, and the FTSE SmallCap has much lower trading volumes and that means the brokers have to widen their bid-offer spread or the difference between the buy and sell price. That makes it much more expensive for investors and, more importantly, fund managers to buy and trade those stocks.

Another key difference between small caps and large caps, at least in the UK, is that the FTSE 100 contains many multinational companies. You can break down revenue by whether it's generated overseas or domestically and for the FTSE 100 about two thirds of the revenue is generated overseas. If we do the same thing for the mid caps in the FTSE 250 the revenue generated is roughly 50 percent domestic and 50% overseas and although it's not shown here for the FTSE SmallCap it's also roughly 50/50, so small caps and mid caps are more domestic than the FTSE 100 but still not completely domestic: there's still 50% of their revenue being generated overseas.

The reason why we're interested in small caps is their performance. Over the last quarter century it's clear that the FTSE 250 has won by a mile compared to small caps and also large caps. Looking at the annualized returns you can see the FTSE 250 has returned about 7% versus the Small Caps 4% and the FTSE 100 is 3%.

Although you often hear that small caps are more risky than large caps in fact their volatility is fairly low it's 11% versus about 18% on the FTSE 100, so volatility might not be the best risk measure to look at when you're comparing these small cap and large cap stocks.

Dividends

A key component of long term return is the dividend you get paid. Dividend is a proportion of the company's profits which is paid to you as a shareholder and the UK market is particularly generous when it comes to dividends which means that it makes up a very large component of long term return.

In the graph above the FTSE 100 Total Return Index is the upper red line and the Total Return Index incorporates that dividend. You can see that boosts the return from the lower to the upper red line. The FTSE 250 also gets a big boost from dividends. In fact, for FTSE 100 it more than doubles the return from 3.1% to 7% over the last nine years. For the FTSE 250 you get about a 4% boost.

One of the problems with small caps is that they don't generate as much dividend because if you're trying to grow a company you plow your profits back into the company to grow organically rather than paying it out to shareholders. Instead, investors rely on capital growth not dividend payments to generate return.

Risk

Although volatility wasn't a good measure of risk looking at what happens during a crisis gives you a better feel for why small caps are risky.

Small caps here are shown in blue and they lost about 60 percent of their value in the credit crisis versus about 50% for the FTSE 250 and about 40% for the FTSE 100.

In the dot-com bubble between 2001 and 2003 the pain was felt more evenly but you can see small caps still came off worst.

Small Cap Trackers

So far we have looked at indices. You can't actually buy an index directly, instead you have to buy a fund which tracks the index. So let's take a look at small cap trackers. Unfortunately, the selection of exchange-traded funds which track the small cap market in the UK is limited to one fund and this is managed by Blackrock under the iShares brand. This fund tracks the MSCI UK small-cap index not the FTSE small-cap index.

Looking at the fund on Morningstar we can see why it's so attractive the long-term projected earnings growth is very high at 10% and over the long term prices will track the earnings growth it's a little bit surprising if you look at the market capitalization breakdown of the fund because you can see that more than half of them are medium caps not small caps it would simply be too expensive to track all those small cap stocks, it would drive up the management fee. Consequently, this fund has been forced to shift the market cap into the mid cap range.

If we look at the MSCI UK small-cap index you can see the largest company has a market cap of over 7 billion euros if we look where that lies on our graph it goes well beyond the small caps which are the blue stocks on the left it eats partially into the mid caps and it's even encroaching into the large cap region which is the red stocks which are in the FTSE 100 looking at the top 10 constituents of that index 5 of them are in the large cap FTSE 100 index four are mid caps in the FTSE 250 and one of them is in the AIM index.

Correlations of CUKS

This tree illustrates the correlation between different funds and indices the fund we're interested in is at the top and it's ticker is CUKS and what you can see is that it's correlation is most tight with the FTSE 250 index tighter in fact than its correlation with the FTSE SmallCap index at almost 95% whereas it's correlation with the small cap index is only 79%. If you're going to buy this fund be aware that it's not just small caps you'll also be buying a very large slice of the FTSE 250.

Global Small Cap Trackers

If you want richer pickings with the small caps you're going to have to go for global small cap funds. Two of the most popular in the UK are the Vanguard global small-cap index fund which has been around for a long time and the newcomer from Blackrock.

Both track the MSCI World SmallCap index, and you can see that Blackrock has tried to take market share from Vanguard by having a very slightly lower ongoing charge of 0.35% per year versus Vanguard's 0.38% per year. Notice that this is much more than you'd pay for tracking a much more large and liquid index like the FTSE 100.

It's always worth looking at the fund fact sheet because this tells you the risks of owning the fund. Some of the most pertinent risks are:

1. This fund doesn't buy all of the stocks in the index in order to reduce the trading fee. Instead, it only buys a subset of the securities that make up the index. The fund manager will avoid trading the least liquid stocks and that will increase the tracking error, which means its price will not track the index perfectly.
2. In order to generate some revenue the stocks which are bought by the fund manager will be lent out to other investors. Some of that money will go to the fund manager Blackrock and some of it will be used to reduce your fee.
3. Don't try to make short-term plays with this index buy it and hold it for the long term because then you'll get the most out of it.
4. Because this is a global small caps fund it is US dollar denominated and that means you take an additional currency risk of sterling versus the US dollar.

You should also be aware that the name of the index which is the world small-cap index actually refers to the developed world. In the graph at the bottom you can see a comparison of the total return with the ACWI small-cap index where AC stands for all country and that includes emerging market stocks like China.

In the bottom right you can see the country weights of the index and as with any developed market stock index it's dominated by the US which makes up about 60% of the index, then we get Japan at 12% and the UK makes up only 7% of the index.

If we compare returns over the last four years you can see the attraction of the global small-cap index the annualized return has been considerably more than UK small caps and far more than the FTSE 250 and the FTSE 100 which had just returned a paltry 4% and 1% over the last four years.

Why Do Small Caps Outperform?

Unfortunately, nobody knows the answer to this question. However, Elroy Dimson's opinion is definitely worth your attention. Dimson is emeritus professor of Finance at London Business School he's also the co-author of a very widely read report which looks at stock performance over a very long period.

His comment here is that the small cap effect seems to have faded in recent decades and if we were to look at this factor for the first time now we'd only find a modest small cap premium. In fact, he says that the reward you get for small caps may simply be due to the illiquidity risk you take by owning them. He also warns against the higher management cost that you get when you have a small cap fund. That's the price of trading something which is illiquid.

This article from Vanguard in the US picks up on that thought and it's a brief dialogue between Frank Chism who's a senior product manager or marketer and the head of the quantitative analysts is called Matthew Jiannino.

When the product group asked the quantitative equity group about producing single factor funds they came up with a fairly standard list of factors such as value and momentum but instead of saying small cap versus large cap they said liquidity and the justification that the quants gave was that many small cap fund managers are just harvesting that liquidity premium. That's why instead of small cap versus large cap Vanguard produces funds which target low liquidity stocks to harvest that liquidity premium and in the diagram in the bottom right they show the liquidity continuum from the largest and most liquid market on the planet which is for US government debt or T-bills then we go through public equities and the sweet spot of liquidity which they point out is between public equities and a combined category of real estate and private equity.

Vanguard have produced both a US liquidity factor fund and a UK liquidity factor fund in the UK you can buy the Vanguard global liquidity factor exchange-traded fund the ticker's VLIQ and I've done a whole video about that Vanguard rank stocks within each regional group combines the scores to form a composite and then buys the least liquid stocks according to that score and they rebalance that portfolio on a regular basis and by doing that they harvest this illiquidity premium the reason why this is interesting is that it provides a cheaper way of getting exposure to the premium you're paid for owning small caps because the ongoing charge for VLIQ is only 0.22% versus 0.35 or 0.38% for the global small-cap index.

Conclusion

Small caps are like an amplified version of the overall market. When times are good and there's a market rally they tend to be better than the overall market and if there's a crash they tend to suffer more. Consequently, if you want to incorporate them as part of your portfolio you've got to be able to stomach that kind of up-and-down motion, or volatility, without selling. Otherwise you could end up getting burnt.