Rolf Banz's 1978 University of Chicago doctoral thesis - "The Relationship between Return and Market Value of Common Stocks" - was dry and technical but contained a striking revelation: In the 40 years leading up to 1975, the smallest one fifth of New York Stock Exchange companies by market capitalization had handily outperformed the largest one fifth. Small, spry companies, goes the theory, grow faster than big, bureaucratic ones. Banz's findings and research by London Business School professor Elroy Dimson showing the same "small-cap effect" in the U.K. spawned a spate of small-cap funds in the 1980s.
But small turned out not to be so beautiful after all. For most of the great bull market of the 1990s, as liquidity chased big blue chips to giddy heights, small-cap stocks as a group languished by comparison. In a world bent on globalization, with trade barriers toppling everywhere, the prevailing view among investment professionals was that large companies with global reach would have better growth prospects than small ones reliant on confining domestic markets. In the three years through January 2000, the MSCI world index of major stocks soared 73 percent, while its small-cap counterpart eked out a 13 percent gain.
Now, however, small is definitely back in style. The Standard & Poor's 500 index, that bellwether of big U.S. stocks, shed 12 percent in 2001, while the Russell 2000 index of small-cap stocks gained 2.5 percent. Internationally, the MSCI world small-cap index broke even as its large-cap equivalent tumbled 21 percent.
Why the role reversal? And is it likely to last? A congeries of factors, from a valuation gap between small and large stocks to incipient global recovery to a wave of mergers and buyouts among small companies, indicate that the small-cap growth spurt has at least a further 12 months to go, say portfolio managers. "Small caps have performed well of late, but we believe there is still plenty of upside," contends Nathalie Degans, who runs $1 billion in international small caps for Morgan Stanley Investment Management. She argues that the valuations of small-cap stocks relative to those of large-cap stocks are "way below long-term averages," so the cycle of small-stock outperformance "has a lot more to run."
Indeed, the yawning valuation gap is the single most compelling reason to buy small stocks today. Even after their trouncing of large-cap stocks last year, small caps have been trading at historically wide valuation spreads vis-á-vis large caps. Merrill Lynch global small-cap strategist Satya Pradhuman notes that U.S. small caps are trading on average at a 10 percent discount to large caps on price to cash flow, which is below their nadir at the bottom of the previous cycle, in 1990. The average S&P 500 stock has a forward price-earnings ratio of 24 times, versus 15 for the typical Russell 2000 share. Similar pricing disparities exist in France, Scandinavia and the U.K., he says. Adds Michael Welsh, a partner at Chicago's Harris Associates, "Eventually the gap between value and price becomes untenable, and either the price goes up or there is an MBO or a financial or trade buyer that comes along."
Timing should also favor small caps, as they've tended to outperform large caps in the early stages of a recovery. Small caps are "an economic story as well as a stock story," asserts Thomas Reilly, head of European operations for Putnam Investments and a longtime U.S. value manager. "This cycle of small-cap outperformance has a long way to run."
Mergers, acquisitions and management buyouts among emerging companies should also give a boost to small caps. A highly rated corporation using its shares to buy a lower-rated small cap of course immediately enhances its earnings per share. And as Merrill's Pradhuman points out, "money is cheap, but more interesting, the relative cost of capital for small and large firms is falling, encouraging many types of entities to borrow" to do acquisitions. Moreover, many family-run businesses in Europe and Asia are poised to go public.
The growth of hedge and mutual funds should bolster European small caps. Less constrained by benchmarks than most institutional investors, they have greater freedom to browse among small caps. "New forces are at work, and they will provide a counterweight to the benchmark-hugging asset managers," says one chief investment officer.
Perhaps the most intriguing case for allocating assets to small caps is that they seem to bring out the best in stock pickers. Consulting firm Frank Russell Co. found that in the 1990s the annualized, compounded real-time mean return of the Russell small-cap manager universe outdistanced the Russell 2000 by a startling 372 basis points a year on average.
This lends credence to the notion that because small caps are underresearched, the market in such stocks is inherently less efficient and therefore offers portfolio managers more opportunity to profit from fundamental research. "Look," says Kenneth Chiang, manager of the $600 million Merrill Lynch Global SmallCap Fund, "there are hundreds of analysts covering IBM all poised to send globally distributed e-mails on every scrap of news. We're not arrogant enough to believe we are smarter than all these people, so instead of trying to compete with them, we look at companies that are neglected by the rest of the market. That makes it easier for us to shine."
Chiang sees the best opportunities in Europe and Asia. "We still like the U.S. and think small caps can continue to do well," he says, "but the tremendous rally in the fourth quarter has overextended valuations in some areas, such as services." He insists that Asia's emerging markets offer compelling values: "Liquidity has concentrated in a handful of stocks, and the valuation discount in small caps is close to 80 percent."
For instance, Chiang likes Indonesian hand-rolled clove cigarette maker H.M. Sampoerna. "I think of it as buying Philip Morris in 1950," he says. "It trades at six times cash flow and has great management. Indonesia has been through wrenching political and economic dislocations in recent years, but Sampoerna can still boast unit volume growth in double figures and continues to put up prices. Maybe people smoke more when times are bad." Any glimmer of recovery in Japan, Chiang adds, would provide a big bounce for small caps there.
Merrill's Pradhuman thinks that active managers will continue to be disproportionately rewarded by small caps. His 2002 outlook - inelegantly entitled "Active Managers Rule, Benchmarks Drool" - reasons that "in uncertain times managers like to take an indexed or quasi-indexed position, but the corollary of our call that investors should be buying small caps is that the worst thing you can do is index, because the indexes are market-cap weighted." Harris Associates' Welsh, calling international small-cap indexes a "joke," points to the large divergences among them.
If international benchmarks are risible, Welsh appears to be having the last laugh. His $200 million Oakmark International Small Cap Fund was up 12.9 percent in 2001, obliterating the MSCI Europe, Australasia and Far East small-cap index's -15 percent return and comfortably besting the MSCI world small-cap index's 0.3 percent. His investment mantra, like that of so many other small-cap managers, is that the greatest rewards come from really getting to know a company. One fruitful acquaintanceship: Hong Kong's department store operator Jusco Stores Co., which in early February was "trading up between 250 and 300 percent from the lows where we started buying," Welsh reports.
Despite their current attraction, international small caps may have a hard time finding their way onto the radar screens of U.S. institutional investors. Such stocks tend to be regarded as just another subset of international equities - an asset class that has been a huge disappointment to American investors. One has to go all the way back to the 1980s to discover a five-year period when a dollar-based investor would have been better off in the MSCI EAFE index than in the S&P 500. What's more, the correlation between U.S. and international stocks seems to be rising, though this is less true of international small caps. Still, as Harris Associates' Welsh points out, only a brave, or foolish, person would presume that a ten-year bull market for the dollar and a ten-year bear market in Japan would persist for another decade.
The person who did so much to launch the original small-stock craze is not convinced that there is any systematic way to capture the small-cap effect. "I wrote the thesis to get a degree, not to make money," confesses Banz, now chief investment officer of Pictet & Cie. As he sees it, the only real way to benefit from small caps is through old-fashioned stock picking, and now is a propitious moment to pay attention to this in-and-out-of-favor asset class.