Why small cap strife means big opportunities in immature companies

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Conventional financial theory has it that, in the long term, shares in smaller businesses outperform those in larger businesses — the so-called small cap premium.

But in the last decade, larger businesses have trounced smaller ones, especially in the US, where they’ve outperformed small caps by 140 per cent.

What happened to that premium?

Perception vs reality

Recent underperformance has largely been driven by indiscriminate derating of valuations, rather than problems with small cap companies themselves. Investors are now less willing than five years ago to pay for small cap earnings. Small cap investors have suffered as a result.

Price to earnings ratio of small cap class relative to large cap

Now valuations are at their lowest levels relative to large caps since 2008, when the global financial crisis scared many investors out of the asset class. In the US they’re as low as they were in 1999, another time when there were a few highly valued IT names and intense concentration in large cap indices. A decade of stellar returns followed the turn of the millennium.

What’s driven this recent underperformance? First, interest rates. Small caps need more external capital and they’re more exposed to rate changes. Their prices tend to be more sensitive, given that expected cashflows lie further in the future. No wonder they’ve suffered from aggressive rate hikes.

Other narratives suggest deeper problems. They present small cap strife as not just a cyclical phenomenon, but as evidence of an asset class doomed to underperform its bigger equivalent. In this reading, the small cap premium is dead and buried.

The size of the pool

For some, the fact that there are fewer listed companies means the scope for outperformance is correspondingly less. Taking the US market as representative, there are now fewer listed businesses than there were 20 years ago. Increased market regulation and more available venture and private equity capital have encouraged companies to stay private for longer – or to delist.

This makes sense. We’ve been investing in private companies for almost a decade, seeking to ensure we don’t miss the disruptors of tomorrow.

But the correlation between volume and outperformance isn’t so simple. It’s the number of the smallest listed companies, the micro caps, that has reduced most. The number of stocks in our favoured small and mid-size category has stayed roughly the same.

This global market remains huge. Our benchmark S&P Global SmallCap index holds more than 11,000 companies, and there are tens of thousands beyond that. The pool may be shrinking, but it’s still much larger than the large cap universe, offering more than enough choice for a portfolio of around 100 stocks.

Only the best

The second argument against small caps is that they tend to be poor quality, with shaky balance sheets, inferior growth prospects, and lower profitability.

There is data to support this. On average, small caps do underperform larger businesses. Large caps have delivered better five-year earnings growth for each of the last five years.

But the term ‘on average’ is key. Yes, most smaller businesses are low quality. But that’s why we’re looking for the exceptional few capable of becoming much larger.

For our experienced team, the ‘average’ small cap is irrelevant. It’s the difference between the best and the worst that’s interesting. The fastest-growing smaller companies continually outperform the fastest-growing larger ones.

Top quintile earnings growth (%)

Bottom quintile earnings growth (%)

We believe the best way to find this exciting growth is through tried-and-tested active management that can filter for quality and potential, ignoring the junk.

Beyond scale benefits

Here’s another argument against small caps: in the digital age, the benefits of scale – data, compute, or storage – are clearer than ever. You only need to look at giants such as NVIDIA, Microsoft, Apple and Alphabet that are driving markets to new heights.

Again, we agree. There’s plenty of evidence for the scale advantage of big tech. An early realisation of this has been hugely beneficial to Baillie Gifford clients over the last decade.

But it doesn’t follow that, because the tech sector shows higher returns to scale, opportunities for disruptive innovation are dead. Far from it. In the 10 years that larger tech companies have dominated, small cap disruptors have still triumphed, seizing opportunities for exponential returns. Taking examples from our transformational holdings that began as small caps:

• DexCom (bought 2012, sold 2021) allowed diabetics to monitor their blood glucose on the go. Its focus and innovation provided the best product, tailored a sales operation and prioritised the amassing of clinical evidence to dominate the US market, outcompeting less focused competitors.
• Tesla (bought 2013, sold 2022) challenged incumbents suffering from the classic ‘innovators dilemma’. The entrenched processes of car makers made them wary of cannibalising their internal combustion model to invest in EVs. Tesla’s ‘first principles’ approach to design, manufacturing, automation and battery technology allowed it to seize the lead.
• Axon (bought 2018) brought disruptive innovation to a traditional area, cornering the market in Tasers, bodycams, and software for law enforcement, a market that competitors ignored. Its products have vastly improved efficiency.

In summary: we don’t deny the shrinking of the small cap universe, the poor quality of many small caps, or the benefits of scale.

But you shouldn’t confuse these factors with proof of an asset class in structural decline. We can equally point to a remaining deep pool of companies, some with incredible growth potential, which can challenge incumbents and win.

On the upside

The good news for our investors is that negative sentiment has lowered valuations, providing an incredible opportunity for long-term stock pickers.

Our strategy is to harness long-term equity asymmetry. We seek the special few that can sustain long-term high growth, delivering multiples of the initial investment. A good barometer for such companies is whether they can deliver a five-times return over five years.

Percentage of companies delivering 5x return

Number of companies delivering 5x return

We recently analysed the proportion of such companies in the US market over the last 20 years. For companies with a market cap between $300m and $10bn, there were 50 per cent more five-times returners than in the S&P 500. That’s a lot.

The difference is even starker when you look at the number of companies delivering a five-times return. Our investable universe produced almost nine times as many five-time returners as the S&P 500.

These outliers tend to be the areas with the most innovation. Technology and healthcare make up 45 per cent of five-times companies, with biotech, semiconductors, and software the highest represented industries.

So, in summary, the small-cap universe remains the place to look for future outliers that can become tomorrow’s tech champions.

Potential, not size

We search for immature greatness, not just small size. Market cap size tells you nothing about potential. We’re looking for four traits:

• Innovation directed at solving big problems
• A defensible competitive edge
• Visionary, high-quality management
• Returns that scale with growth

Companies with all four have a higher chance of delivering outsized returns.

What then do tomorrow’s disruptors look like? Experience has led us to some promising categories, including healthcare, digital infrastructure and transformative hardware. Here are some examples:

Summing up

The prevailing narrative is that small caps will continue to underperform as the universe narrows, their quality deteriorates and each company will have a progressively lower chance against the giants of the digital age. There’s some truth in this, but it’s not the whole story.

The small cap market remains incredibly deep and broad. For us it remains the place to hunt for early-stage, disruptive outliers.

Investors with decades of experience and a proven record of success, backed by Baillie Gifford’s stable and supportive partnership structure, are best placed to find the diamonds amid the dross.

As technology continues to transform society, current indifference towards small caps only increases the upside of these potential disruptors. There’s never been a better time to invest in these companies and our style of investing is up to the challenge – and the opportunity.

Glossary of terms:

Small cap: a public company with a market capitalisation of between $250 million and $10 billion.

Large cap: a company with a market capitalisation value of more than $10 billion.

Price-to-earnings: The price-to-earnings (P/E) ratio measures a company's share price relative to its earnings per share (EPS).

Top/bottom quintile earnings growth: A quintile is representative of 20 per cent of a given data set, dividing it into five equally sized groups. Those in the bottom quintile are the 20 per cent with the lowest earnings. Those in the top quintile are the 20 per cent with the highest earnings.

*Inception date: 30 June 2017.

Source: Revolution, MSCI. US dollars. Returns have been calculated by reducing the gross return by the highest annual management fee for the composite. 1 year figures are not annualised.

Past performance is not a guide to future returns.

Legal notice: MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indexes or any securities or financial products. This report is not approved, endorsed, reviewed or produced by MSCI. None of the MSCI data is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such.

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This communication was produced and approved in November 2024 and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.

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Past performance is not a guide to future returns.

Legal notice: MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indexes or any securities or financial products. This report is not approved, endorsed, reviewed or produced by MSCI. None of the MSCI data is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such.

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