Small- and Mid-Caps with optimised returns

Shares of small and medium-sized companies outperform those of large corporations. But higher returns can generally only be achieved by taking on an increased risk. A new study confirms the opposite for small companies.

On the European stock markets, the number of large caps has increased dramatically, and they have never made up such a large proportion of the total market capitalisation. A new study from the French investment boutique La Financière de l`Echiquier (LFDE) and the research institute MiddleNext shows that the markets are preferring large caps on the expense of small and medium-sized companies: While large caps account for only seven percent of listed firms, they accumulate 80 percent of traded volume. Moreover, the number of small caps has decreased since the financial crisis.

However, it seems that investors are doing a wrong to small companies. The study shows that smaller firms outperform larger corporations and doing so, even at a lower risk. Pursuing the analysis, the Europe’s 200 largest companies show an average annualised performance of about one percent. The Europe Mid 200 and the Europe Small 200, however, have an annualised performance of respectively 4,6 and 4,8 percent between 2005 and 2015.

While the size factors, i.e. the market capitalisation, has been confirmed as a driver of stock returns in numerous studies already and was integrated into financial models forecasting and analysing stock returns such as the three-factor model of Fama and French, the study of LFDE and MiddleNext shows that this empirical outperformance was achieved at lower levels of risk during the last three years - despite the academic statement that a higher return can only be achieved with a higher risk. 

While the volatility of large stocks was about 13 percent, it amounted to only twelve percent for small and mid caps. For micros stocks represented in the study through the MSCI Micro Cap Index, the volatility accounted to only ten percent. Thereby, small companies show a tighter distribution, and thus more certain, returns.
Also, the maximum drawdown was lower: While the maximum accumulated loss accounted to 13 percent for large stocks, it was at only 11 percent for mid caps, eight percent for small caps and seven percent for micro caps. Smaller companies are thus also recovering from losses faster or not even falling that deep.

However, higher returns and lower risk are against the logic of markets. LFDE still tries to identify reasons for this development: One explanation might be the low interest rate environment that forces investors to look for riskier investments to achieve satisfying returns. This drives them into small caps and thereby increases their prices and returns. Moreover, smaller companies have a lower exposure to global trends. The slowdown of the Chinese economy, for example, effects every multinational corporation but small caps much less, as they concentrate more on their home market.