So in the spirit of both these sayings I am always interested in checking my base assumptions for reality. Though in the interest of full disclosure Mark Twain was a keen and ultimately awful investor. Some of his work and much of his touring was driven by the need to recoup money he had lost in bad investments.
I have historically believed that Small Cap investing beats the market and that there are two main reasons for why this is so;
1 – One reason that Small Cap investing generates better returns is that “Trees do not grow to the sky”. As such a smaller company, all other things being equal, has a longer runway on which to grow. So it is comparatively easier for it to double in size than an already large company already fully addressing its market.
2 – The other main reason that small cap investing generates better returns is that; Smaller companies are less researched and so wonderful opportunities are mispriced. As they become properly understood the early investor can reap significantly better than market returns. Wheras larger companies are reviewed by many analysts and widely known, followed and invested in. To the extent there is a “perfect market” hypothesis it applies more to large caps than small caps.
However AQR ($229bn) has recently released a report “Fact, fiction and the Size effect”. This argues that in reality there is no identifiable positive small cap effect. That is not to say one may never have existed but it does suggest that one does not currently exist.
In the report and elsewhere there are explanations as to why neither of the historically identified effects are valid in an ongoing basis.
Whilst “no tree grows to the sky” in the context of modern business nobody knows where the sky is. Using Amazon as an example;
It began as a US bookseller.
Then a bookseller to western economies.
Then it has become a seller of a vast array of goods in certain countries.
Then people noticed it was, through Amazon Web Services a major provider of web based services.
Then it began expanding to non-western countries.
Via Amazon Prime/Movie/Music it has got into film and video.
It has a hardware division for phones, tablets, etc
The Alexa system enters it into digital assistants.
And via Amazon essentials it is a provider of its own branded goods into many areas and is adding more.
All of these are changes I missed, but all of these demonstrate that in the modern world it is increasingly possible to develop into new geographical markets and for many large companies into new product areas. Google – You Tube, Facebook – Instagram. Apple – Services etc.
So whilst it remains true that no tree can grow to the sky. It is also true that from one tree you can over time get a forest.
With regard to smaller companies being less researched and thereby allowing for mispricing this too may now be untrue; if in fact this ever was the case.
There are 4 reasons for considering this;
1 – With the growth of Passive Investing an increasing amount of shares are not bought because of research they are brought because they constitute part of the index. To the extent this is a small cap or whole market index they will be bought, effectively without research.
2- With the rise of quantative investing and algorithmic trading there is an increasing reality that small cap/unknown shares will in fact be bought in proportion to their data set. Historically humans did perhaps not have the time or information to look at smaller companies, but computers trading and algorithmic system can in minutes access and trade most of the shares in the world. Given the company is small it may be that the quant trading will represent a significant part of the trading in that share and as such move to eliminate mispricing in a way that did not historically happen. There is an underlying contention put forward by Ritholtz Wealth Management from the AQR report that it is larger companies that may provide mispricing as they are the ones that humans will swing into and out of as they are the ones that humans have heard of and will misprice. Tesla may be an example of this.
3 – Direct share ownership was traditionally quite hard to get into and there were various transaction costs involved. With the growth of the internet buying shares has become much easier and as such potentially more widely distributed. (I am aware that research suggests that absolute individual shareholding has decreased. But so has the number of publicly traded companies). As such in any Small company scenario there are in fact a number of people, Directors, employees, suppliers, customers who know about the company and have the ability to buy its shares. Because it is a small cap individual buying or selling can have a direct effect on the price. In a way that is not the case for Shell or BP.
4-It is very clear that significant mistakes have been routinely made in pricing large companies. $AAPL at $68. $AMZN at $295. £RDSB at £13.50. All of these have been prices available in the last few years. Yet each company’s share price is today at least twice as much.
Now I have to admit that I am a bit of an AQR fanboy. So if they say something is so I do not dismiss it out of hand because I initially disagree with it. And to be clear AQR is the only company that I have seen with research suggesting small company relative results are less than previously claimed. But the rational for why there is no longer an advantage makes some sense to me and as such i THINK is well worth consideration.
As always DYOR.