http://www.liberum.com/news/2015/march/seb-on-small-stocks
Size matters. Small Cap stocks are rarely this attractive
It's well documented in academia that smaller companies tend to perform better over time horizons of 10 years or more. This is particularly evident in the UK, where we see good performance from the very smallest companies and bad performance from the very largest companies.
£100 invested in the FTSE 250 on January 1st 1997 would be worth £593 now. By comparison, the FTSE 100 would have returned just £287.
This is largely down to the FTSE 100 being dominated by around 20 very large firms - the megacaps - which have historically been mostly Banking, Mining, Oil & Gas and Telecoms companies. The performance of the megacaps since 1997 has been relatively weak, offsetting the much stronger performance of the 80 smaller firms in the FTSE 100 and holding back the index.
This chart shows the return on £100 since 1997 from UK indices.
One key reason why smaller companies tend to generate better returns in the long term is the existence of a 'liquidity discount' that evaporates as they grow into larger businesses.
Institutional investors are willing to pay a higher price for a stock, all else being equal, if they can enter and exit positions quickly and without moving the market. This translates into broadly higher multiples (P/E EV / EBITDA etc.) on larger companies for a given level of earnings growth.
This effect has been particularly exaggerated of late. Not only has liquidity in small cap worsened markedly over the last 12-18 months, but the premium investors are willing to pay for liquidity has risen – likely a result of the 'lobster pot' rotation out of small cap witnessed in April-June last year which left small cap 'tourists' particularly scarred.
This chart shows the number of days it takes to trade 10% of a stock.
We therefore find the FTSE Small Cap index currently at a post-crisis record discount to the FTSE 100. It is trading, as a whole, on 13.2x 12m fwd P/E vs. the FTSE 100 on 15.8x – a 17% discount.
We can expect this to normalise, as it has done in the past, if liquidity improves or if risk appetite for illiquid companies returns.
Another key factor cited by…
