Less noticed are the risks that are lower for smaller companies than large. But investors also need to understand the risks that are neither greater not smaller, but simply different. These provide holistic view of the asset class and a potential source of risk diversification.
Finally, investors cannot ignore the risk factors that are common to all companies, large and small.
Identifying the small-cap premium
A smaller company can have a lower market value for two reasons:
- It’s small (which investors can measure in several ways)
- It’s relatively risky
Investors should apply a higher discount rate to future cash flows of more risky companies. A higher discount rate means a lower valuation. In other words, for two companies with the same annual sales, the more risky company will have the smaller market capitalization. Understanding these risks can help reveal the value of a company.
Understanding these risks can help reveal the value of a company.
In general, one could explain the small-cap premium as the reward for accepting smaller companies’ potentially poor performance during times of market stress. Investors must decide if the reward is worth this risk. The bottom line is that companies that comprise small-cap indices collectively present higher risks than the companies that make up large-cap indices. But this doesn’t mean that small-cap companies can’t be a valuable part of an investment portfolio. Investors can try to control these risks in their portfolios, perhaps by tilting toward higher-quality smaller companies, for example.
Higher risk
1. lliquidity risk — The shares of smaller companies are less liquid than shares of their larger peers. They also have higher insider ownership, leaving a smaller free-float for external shareholders. This risk can be mitigated in a portfolio context. However, it translates into a higher cost for entering and exiting positions.
2. Recession risk — Smaller companies have historically underperformed their larger peers during recessions and bear markets. Consider a few 21st century market downturns. During the market pullback associated with the Dot-com bubble,1 small caps2 modestly underperformed large caps,3 turning in -44% compared to -43%.4 We observe a similar pattern during the Global Financial Crisis,5 when small caps turned in -54% versus -51% for large caps.6 Most recently, this pattern played out as the market hit its lowest point of the Covid crisis. During this time,7 small caps returned -41%, while large caps returned -34%.8
But it’s worth remembering that we’re only able to identify recessions or bear markets with such precision in hindsight. It’s also important to bear in mind that economic downturns and market downturns don’t always neatly coincide.
3. Credit risk — The cost of borrowing is higher for smaller companies. Indeed, the cost of equity is higher, too. Lower average valuations for share buyers translate into higher cost for the companies issuing those shares. This is consistent with the underperformance of smaller company shares when times are tough. The small-cap premium is higher when interest rates are low than when they are high. And higher when interest rates are falling than when they are rising.
4. Inflation risk — When supply is tight and demand is high, inflation may rise. During these times of rising inflation, small companies may face more difficulties than their larger peers because they have to fight harder to absorb higher expenses. Smaller companies tend to be more labor intensive than large companies, so if the cost of labor increases during a period of increased inflation, small-cap company profits could be at risk.
5. Price volatility — All of these risks translate into higher volatility of returns for an index of smaller companies than their larger peers.
Lower risk
6. Complexity — Big companies are complex. “Jack-of-all-trades” mega-companies even more so. Smaller companies tend to be more niche and focused. Inherently, there’s a lower risk of complexity in a company with a single area of focus than a large one with its fingers in several buckets.
7. Index concentration — The composition of market indices reflects past success. Sometimes, one theme dominates the market. Today, for example, the US tech-centered FAANG stocks (Facebook, Apple, Amazon, Netflix, Google/Alphabet), represent about 19% of the S&P 500 Index.9 Other single-country indices face similar concentrations. For example, Samsung Electronics represents 29% of the MSCI Korea Index.10 A few large stocks can skew the overall performance of market-cap weighted equity portfolios. Because smaller companies have smaller market capitalizations, their indices aren’t as likely to reflect huge concentrations in the way a large-cap index that’s home to a massive market-cap company is.
Different risks
8. Currency exposure — smaller companies have a higher proportion of domestic sales compared to large, multinational companies because they’re typically more niche and focused on local customers. In the US, for example, 79% of sales for companies in the S&P SmallCap 600 Index were domestic in 2019. This compares to 62% for the companies comprising the S&P 500 Index.11 This means that small and large companies have different responses to currency moves.
9. Stock-specific risk — stock-specific risks drive performance for smaller companies more dramatically than for larger companies. By contrast, larger companies are more sensitive to other factors such as country, sector and style.
Chart 1: Average asset level % stock-specific risk
10. Different companies — a small-cap portfolio represents a whole different set of companies than a large-cap portfolio. It’s a basic fact, but an important one not to lose sight of. The MSCI ACWI Small Cap Index, representative of global small caps, has 6,233 constituents. This is more than double the number of companies included in the proxy for global large-cap equities, the MSCI ACWI Index, which has 2,975 constituents.12 Each of these companies has different pros and cons and different exposures to risk.
11. Long-cycle performance — These different risks help explain why capturing the small-cap premium involves periods of outperformance and underperformance. The cycle between small-cap and large-cap leadership differs across different countries. These cycles can last for several years.
Same risks
12. Traditional risk measures — Portfolio managers still need to take account of country, sector and industry exposures when considering a small-cap allocation. And they need to understand their exposure to style factors including quality, momentum and value. In particular, they need to be aware of stock-specific risks. All of these risks are common among any asset class, and can best be understood through fundamental analysis. Understanding the risks of small-cap investing and comparing the risks for this asset class to others is a critical part of determining a potential small-cap allocation.
DIGGING DEEPER
How does a portfolio of smaller companies differ from a portfolio of larger companies? We provide facts and figures to illustrate the differences.
Company fundamentals — Smaller companies are in general less profitable than their larger peers. They also have lower debt ratios.
Country and industry weights — There are differences in sector exposure between the MSCI AC World Index and the MSCI ACWI Small Cap Index (Chart 2). The smaller companies index has higher weights in industrials, whereas the larger companies index has a higher weight to information technology.
Chart 2: Sector exposures vary between small-cap and large-cap indices
By contrast, there are fewer differences between country weights. For example, the large-cap index has about 7% higher exposure to the US, while the small-cap index has about 3% higher exposure to Japan.
Chart 3: Large vs. small cap country weights
Source: MSCI, September 30, 2021. Small cap represented by MSCI ACWI Small Cap Index. Large cap represented by MSCI World Index.
Analyst coverage — 61% of companies included in the MSCI ACWI Small Index have seven analysts or fewer. This compares to 15% of companies in the MSCI AC World Index. 13
1 March 10, 2000 – October 9, 20022 As represented by the Russell 2000 Index
3 As represented by the S&P 500 Index
4 Source: abrdn, FactSet, Bloomberg as of September 30, 2021. No fees or expenses are reflected. You cannot invest directly in an index. No fees or expenses are reflected. For illustrative purposes only.
5 June 6, 2008 – March 9, 2009
6 Source: abrdn, FactSet, Bloomberg as of September 30, 2021. No fees or expenses are reflected. You cannot invest directly in an index. No fees or expenses are reflected. For illustrative purposes only.
7February 21, 2020 – March 23, 2020
8 Source: abrdn, FactSet, Bloomberg as of September 30, 2021. No fees or expenses are reflected. You cannot invest directly in an index. No fees or expenses are reflected. For illustrative purposes only.
9 Investopedia, “FAANG Stocks,” August 2021.
10 MSCI, August 31, 2021.
11 Forbes, “Investing Basics: Large-Cap Stocks,” October 27, 2021.
12 MSCI, as of September 31, 2021.
13 As of October 31, 2021
IMPORTANT INFORMATION
Past performance is not an indication of future results. Indexes are unmanaged and have been provided for comparison purposes only.
Equity stocks of small and mid-cap companies carry greater risk, and more volatility than equity stocks of larger, more established companies.
Diversification does not ensure a profit or protect against a loss in a declining market.
Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.
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