Forget the conventional wisdom: large caps beat small caps in Australia

The reality is that some factors tend to deliver better risk-reward than others.

The reality is that some factors tend to deliver better risk-reward than others. Picture: AAP

It may surprise investors to hear that large capitalisation stocks have beaten small caps over all periods except the past 12 months, contrary to the conventional wisdom that small cap returns beat larger companies.

There are several factors that drive share returns. “Value” investing involves buying stocks with low prices relative to their fundamentals such as earnings while “quality” companies are those with healthy balance sheets and strong returns on capital. “Momentum” investing involves buying companies with strong performance trends.

But the reality is that some factors tend to deliver better risk-reward than others.

 The theory that underpins supposed small cap outperformance rests on the idea they grow faster — a conclusion of much research, most famously from academics Eugene Fama and Kenneth French. They found smaller companies outperformed larger ones over the longer term, with investors being rewarded for the greater risk in backing more volatile small caps. 

But our factor analysis reveals that over longer-term periods of 10 and 20 years, Australian large cap stocks outperformed small caps convincingly. The research highlights this outperformance over three, five, 10 and 20 years.

 Why? It has much to do with the concentration of the ASX 200 in large financial and mining stocks. The weight of money has been directed to just a few big stocks, the big banks and miners. Investors’ money, both actively and passively managed, has piled into these big stocks. They include all the big four banks, BHP and Rio, healthcare giant CSL and Telstra. This has entrenched the gains of large caps over small caps over the longer term.

Over the shorter periods, the story is not dissimilar. We found that large caps consistently outperformed small caps across all major market crises. This is exactly what happened in the first month of the COVID-19 crisis, though small caps rebounded strongly after the first 30 days. The pandemic resulted in large cap, quality and growth factors delivering positive premiums. The impact of the pandemic on factor returns has been much more severe (in speed and depth) than the previous major crises, particularly during the first 30 days.

 At the same time, in contrast to previous crises, the value factor has underperformed growth while aggressive asset growth beat conservative asset growth.

 Given the pattern of the large cap factor performance behaviour during the previous three crises, investors can reasonably expect the large caps to outperform during future market crises.

 Factor investing is often captured by active fund managers investing in assets with particular attributes such as value stocks or small caps, or “smart beta” ETFs that track a rules-based index.

For any investor, it is important to understand how factors work when evaluating your investment performance and making decisions to hire or fire a manager or invest in a particular product.

Some factors give better risk-adjusted returns than others. And despite the rhetoric from some investors, backing smaller, riskier stocks won’t necessarily give better returns than backing larger, less volatile stocks.

Our market is just too concentrated for that.

What’s more, investors can manage the negative drag from the size factor by avoiding passive and smart beta strategies that seek to just maximise exposure to the size factor without paying any regard to other fundamentals.

Investors would be better served by selecting skilled small cap active managers with a proven track record of managing the size factor headwinds while seeking to add value by picking strong companies in the small cap space.

Jay Kumar is founder and managing director of Foresight Analytics.

www.foresight-analytics.com