Little Monsters: Boom or Bust? – The Size Effect

The stock market is made up of a plethora of different beasts. From lethargic old giants to the spritely spirits of the small-cap index. Zach Chadwick, an analyst within the J.P. Morgan Asset Management UK equity team, discusses how these different size companies tend to perform through the cycle and explore why this is the case.

Go to the profile of Zach Chadwick
Nov 20, 2018

What is the size effect?

Fama and Frenchi found that, in the long term, small-cap companies tend to see higher returns than large-cap companies. Intuitively, this makes sense. For HSBC, one of the largest names in the FTSE 100, to grow revenues 10% means finding another £5 billion of revenue. In contrast, a smaller company, such as Games Workshop, needs an extra £20 million to achieve the same growth rate. A higher growth rate in smaller companies is more achievable in monetary terms than for their larger counterparts. If we look at the small-cap index in the (very) long run, it is clear that smaller companies have outperformed their larger peers. Between 1955 and 2013, the UK Small-Cap index generated an annual return of 15.8% ii, compared with 12% for the market as a whole. When you compound this growth, the small-cap index has returned a mighty 11,605%!

As a fund manager once noted: “If I had to back a mosquito or a mammoth in a straight fight, I’d back the mammoth every time. Yet at a species level, mosquitoes have evidently proved a lot less ‘risky’ than mammoths.”  iii

However, investing in these smaller names can be tricky, for three main reasons:

  1. Liquidity

By their very nature, these companies have a small market cap and often an even smaller free float. This can exaggerate price moves drastically around liquidity events and these stocks can therefore often take longer to price in news as a result. 

2.  Coverage

As there is limited coverage of much of the small-cap index, behavioural biases—such as herding—can be more prominent. For example, if an analyst picks up coverage of a hot stock and it gains momentum, the next analyst will wake up to the news and more backers will eventually come flooding in. In the small-cap arena, this cycle can become self-fulfilling.

3. Communication with the market

While many larger companies have whole teams dedicated to investor relations and can afford to publish frequent updates on their progress, smaller companies will often not have this ability. This can lead to more frequent positive and negative surprises as a lot can change between the release of semi-annual reports.

As a result, entering and exiting small-cap stocks can prove difficult. As low liquidity and poor coverage combine, growth can be priced in well ahead of any actual growth materialising. On the flip side, the trap door can open up beneath stocks when growth disappoints. Looking at the past two cycles in UK equities from a large cap (FTSE 100) vs. small cap (FTSE Small Cap) perspective, as well as the current cycle, provides some interesting observations. 

The chart below summarises the three periods I have looked at. 

Figure 1: Total return of the FTSE 100 index vs the Small Cap Index rebased from 1995 as at 5/11/18. Source: Bloomberg. Past performance is not a reliable indicator of current and future results. 

Figure 2: Total return indexes rebased from 01/09/1990 as at 5/11/18. Source: Bloomberg. Past performance is not a reliable indicator of current and future results.

1. The Tech Bubble 

  • This period was characterised by investors flocking into large-cap tech stocks

  • This size bias led to outperformance of the larger names in the FTSE 100

  • This is the only decade where small caps have underperformed large caps since the 1950s (the start of our records)

  • The subsequent correction was pretty similar among both small and large-cap names

  2.  The Global Financial Crisis

Figure 3: Total return indexes rebased from 01/03/2003 as at 5/11/18. Source: Bloomberg. Past performance is not a reliable indicator of current and future results. 

  • Small caps massively outperformed their larger peers from 2003 to mid-2007

  • New technology improved the liquidity and coverage of small-cap names

  • Investors flocked into small caps and their performance swelled

  • But the small-cap index corrected heavily in 2008 and by 2009 all of this outperformance was lost

  • The FTSE 100 was down 40% from peak to trough

  • The FTSE Small Cap Index was down 56% from peak to trough

3. Where are we now?

Figure 4: Total return indexes rebased from 31/03/2009 as at 5/11/18. Source: Bloomberg. Past performance is not a reliable indicator of current and future results.

  • Low interest rate environment has pushed investors to look for yield in all corners of the market

  • Low rates have allowed corporates, in particular small caps, access to cheap debt

  • Small caps have provided strong capital growth and have massively outperformed as investors have piled in

  • Note the scale of small-cap outperformance vs. the Global Financial Crisis  

Smaller companies have engorged on cheap debt…

Historically, small caps have outperformed in a rising rate environment. As central banks raise rates, the cost of debt for corporates increases with it. Small caps have normally been funded by equity instead of debt so they have been less sensitive to interest rate movements relative to the debt laden larger caps.

However, in this cycle large caps have prudently delivered from their peak of 6.4x net debt to EBITDA in 2008 to 1.4x today. In contrast, small caps have only reduced debt from 4.7x to 3.4x. Our Small-Cap Team pointed out that a big reason for this is the high weighting of real estate names in the Small Cap Index, at 10.6% vs. only 1% in the FTSE 100. This weighting has doubled since 2008 and excluding them puts the index at a multiple that is closer to the FTSE 100 figure. Highly levered small-cap real estate companies are still a danger and have therefore been included in the dataset below. Looking at leverage in a different way, we see the same picture: the total debt to total assets is 25x in the small cap index and 15x in the FTSE 100. iv

Figure 5: FTSE 100 index vs FTSE Small Cap Index Ex Investment Trusts as at 5/11/18. Source: Bloomberg

Valuation, valuation, valuation

So are these valuations looking stretched? On a price-to-earnings (P/E) basis, they are in line with the FTSE 100 and mid-cap indices.

Figure 6: One year forward Price to Earnings (P/E) Ratio. Source: Bloomberg, From S1 2004 and as at 5/11/18

As you can see, small-cap valuations were not particularly stretched in previous cycles. The issue is that the reliability of earnings in smaller companies is often lower. Large-cap names are likely to be relative outperformers when/if there is a recession as they generally have a broader product base, wider geographical reach and are now more stable financially. It is the long period of outperformance as the small caps have geared into the bull market that concerns me, as for these same reasons small caps are likely to underperform when the going gets tough. Not to mention with the negative impact that MiFID II may be expected to have on liquidity and coverage in the small cap sector.

UK fund managers are heavily overweight small and mid-caps

This chart shows how overweight UK fund managers tend to be to the small and mid-cap portions of the index. For many investors’ portfolios, this may be the biggest implicit bet they have.

Figure 7: Exposure to small & mid cap companies is the exposure of flexible cap UK funds. Shaded regions represent the 75th percentile (top line) and the 25th percentile (bottom line). As at July 2018. Morningstar ‘All rights reserved’, J.P. Morgan Asset Management.  


In conclusion, the Small Cap Index has historically outperformed over the very long run. But, it does have sustained periods of heavy underperformance vs its larger brethren. Currently, the extra leverage compared to history, and risks associated with small caps, combined with the potential liquidity constraints from the heavy overweight position in smaller companies, could make a mean reversion of FTSE Small Cap performance extremely painful for a lot of UK fund managers. During this current period of elevated volatility, it is worth bearing in mind your exposure to size vs. the index.  This would suggest a balanced exposure and diversification within a portfolio, not just in the type of company but also in the size of those companies, alongside other considerations.

Zach Chadwick is an analyst within the J.P. Morgan Asset Management UK equity team. Read more about our UK Capabilities >


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i Fama, E. F.; French, K. R. (1992). "The Cross-Section of Expected Stock Returns".


iiii Premier Asset Management - Simon Evan-Cook,

iv Bloomberg 

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Go to the profile of Zach Chadwick

Zach Chadwick

Analyst, UK Equity Group, J.P. Morgan Asset Management

Zach Chadwick is an analyst in the J.P. Morgan Asset Management UK Equity Group.

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