Family investment primer – Listed small-caps fade as venture dominates


Forty years ago, in June 1979, Rolf Banz sent his first draft of research to the Journal of Financial Economics arguing that risk-adjusted returns for small company stocks trounced large caps, over time.

By his calculations, this “size effect” had worked for forty years and investors willingly backed his analysis. His reputation secured, Banz moved from academia to private bank and family office adviser Pictet, recently becoming a senior adviser to the London Business School.

Family offices and endowments are coming to terms with the fact that value and small-cap managers have failed to deliver for several years

Another academic, Eugene Fama, agreed that small caps and value stocks outperformed in 1992. He won a Nobel Economics prize for his research.

Back then, movements in markets, proved all their points. Family offices and endowments lapped up their wisdom, including David Swensen, redoubtable investment chief at the Yale Endowment.

As of now, however, family offices and endowments are coming to terms with the fact that value and small-cap managers have failed to deliver for several years.

Dan Rasmussen, founder of small-cap investor Verdad, points out the broad US market shows an annualised 9.5% over five years, against 1.5% for international stocks. A return of 5.4% for US small-cap value in the US compares to a rise of 0.8% in their worth abroad. 

Vanguard’s small-cap value index fund has produced an annualised 6.8% over five years, against 10.6% from its S&P large-cap index fund. Its small-cap fund has risen by 12.3% over ten years, rather less than the 13.5% from the S&P index.   AB Bernstein research published in March suggested that the pricing gap between value and growth is at its widest for seventy years. 

Verdad’s Rasmussen points out small-cap, international and overseas markets have bounced back over two months. Research from Credit Suisse bears this out.

Small-cap still has big fans. According to asset manager Axa Rosenberg: “Small caps provide tremendous opportunities for active managers”. 

The argument runs that shares get mispriced due to reduced income in small-cap, compared to large-cap. Young companies can be relatively dynamic compared to old economy stocks. Success for companies with a small number of shares listed produces disproportionate gains.

However, the headwinds facing small caps have been putting the “size effect” to a severe test. And much of this relates to the changing way funds have been flowing. 

Fifty years ago, private investors were enthusiastic supporters of small companies, who then relied on stock markets to raise capital.  

Institutional equity portfolios had a large weighting in small caps because they outperformed, and managers loved to prise information out of their managements.

But private investors have drifted towards pooled and passive funds. Institutional clients have dramatically reduced their allocations to small caps to invest in bonds. 

Instead, liquidity is coming from wealthy individuals, endowments, family offices, private equity, venture capital, and corporate venture funds. These folk are fascinated by the way technology is changing commerce. They are anything but fascinated by old economy small-cap stocks. To his credit, Yale’s Swensen has invested heavily in venture. 

These new-age investors take their cue from Microsoft which has achieved annualised share price gains of 20%-plus for thirty years. Similar growth has taken place at rival big tech stocks, encouraging investors to speculate on continuing growth from similar stocks in an increasing range of sectors. Healthcare is currently seen as ripe for disruption. 

It has also become clear that large companies which have invested heavily in the big data and best technological tools are far better placed to grow market share than old economy stocks. So much for the old “size effect”. 

Investors are also using more technology. They are less inclined to act on a hunch or a tasty bit of gossip. In short, they are being reprogrammed.

Meanwhile, corporate innovators have grabbed the opportunity to raise finance from the private markets, which do not expect them to supply tedious data on their pay and governance. 

They can rely on successive waves of venture funding to fund stages of their development, including cash supplied by their tech-driven peers. 

If or when companies finally float, they often make their debut as a mid or large-cap companies rather than a small caps struggling to get attention. Floats can be deferred for years. Some innovators prefer to strike deals with corporate venture or private equity funds rather than get involved with a time-consuming IPO.

Investors are little more cautious following the failure of WeWork’s float. But there is still plenty of debt and equity finance available to support deals.

10x Genomics makes gene-sequencing technology. Its shares listed at $39 in September and now trade at $60, skipping the small-cap phase by valuing the company at $4.9 billion. Backers include Softbank and VenRock, backed by members of the Rockefeller family. 

Travis Kalanick left Uber in 2017 under a governance cloud, but he has raised $400 million from the Saudi sovereign wealth fund for CloudKitchens, supplying delivery firms with cooked food.  It would have been harder for him to raise the money from the stock market. Private investors are relatively forgiving.

As tech rises, you can also see the risk of a growing number of poorly managed, old economy stocks, drifting down the stock market and finishing up in the small-cap sector. 

They may not go into receivership, given low-interest rates, but they can easily end up as Zombie stocks, ignored by investors and a drag on small-cap indices.  

It’s possible, of course, that value and small-cap stocks will build on their recent recovery. Many of them are undervalued and pay decent dividends. 

Historically, value and small-cap do have a habit of lagging for long periods, as was the case during the 1990s tech bubble.

But the changes have become entrenched. We are going to need an awful lot of tech-driven stocks to hit the wall to see a dramatic improvement in prospects for the old economy. 

And, somehow, I just don’t see it. 


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