Small Caps Versus Large Caps: Which Is Best?

Small Caps Versus Large Caps: Which Is Best?

one of the questions from our patreon
sponsors was about small caps versus large caps which is best and what kind
of environments would you buy one over the other so let’s find out about that
in a bit more detail this is not a recommendation if you want advice
tailored to your specific circumstances seek independent financial advice let’s
start out with the UK market looking at small caps versus large caps a small cap
is just a small company for example Topps Tiles has a total of about 200
million shares at the time of this recording each of those shares was worth
63 pence and 200 million times 63p gives you 124 million pounds that’s the
market cap of Topps Tiles which is the total value of all its shares and that
is a tiny company when we compare it with a large cap company like Royal
Dutch Shell that has almost a billion shares in issue each of which is worth
25 pounds multiply the two together and the market cap is over 200 billion so
you can see the massive disparity between the small companies and the
large companies which trade on the London Stock Exchange there’s a roughly
2000 fold difference between the tiny companies and the huge companies and
there’s also a fundamental difference between the way the two types of stock
trade in this diagram companies are ranked from largest at the top to
smallest at the bottom by market capitalization the FTSE 100 contains
the largest 100 companies then the next 250 largest go into the FTSE 250 and
we call those mid cap companies and all of the rest from 351 down to about 620
go into the FTSE SmallCap there’s also a FTSE 350 which is the 100 and
250 combined and the FTSE AllShare which contains everything now the
fundamental concept that you have to understand when thinking about small
caps is called liquidity liquidity tells you how easy fast and cheap it is to buy
and sell a company’s stocks and if you understand this graph you’ll pretty much
understand what liquidity is this contains all of the FTSE AllShare
stocks which trade on the London Stock Exchange small caps are on the left and
large caps are on the right and on the y-axis we have high liquidity
at the bottom and low liquidity at the top and for liquidity we’ve used the
difference between the buying price and the selling price of the stock so for
the low liquidity stocks they’re more expensive to trade I’ve colour coded the
FTSE 100 in red so those are the large caps at the bottom right and you
can see that because they’re large cap they trade millions of pounds worth of
shares every day and they’re very high liquidity brokers don’t have to make
such a big markup because they trade a very large volume of shares every day
the FTSE 250 which is mid caps is in green and the FTSE SmallCap has much
lower trading volumes and that means the brokers have to widen their bid-offer
spread or the difference between the buy and sell price that makes it much more
expensive for investors and more importantly fund managers to buy and
trade those stocks another key difference between small caps and large
caps at least in the UK is that the FTSE 100 contains many multinational
companies and you can break down revenue by whether it’s generated overseas or
domestically and for the FTSE 100 about two thirds of the revenue is
generated overseas and if we do the same thing for the mid caps in the FTSE
250 the revenue generated is roughly 50 percent domestic and 50% overseas and
although it’s not shown here for the footsie small cap it’s also roughly
50/50 so small caps and mid caps are more domestic than the FTSE 100 but
still not completely domestic there’s still 50% of their revenue being
generated overseas the reason why we’re interested in small caps is their
performance over the last quarter century it’s clear that the footsie 250
has won by a mile compared to small caps and also large caps
looking at the annualized returns you can see the FTSE 250 has returned about 7
percent versus the Small Caps 4% and the FTSE 100 is 3%
and although you often hear that small caps are more risky than large caps in
fact their volatility is fairly low it’s 11% versus about 18% on the FTSE 100
so if volatility might not be the best risk measure to look at when you’re
comparing these small cap and large cap stocks a key component of long term
return is the dividend you get paid that’s a proportion of the company’s
profits which is paid to you as a shareholder and the UK market’s
particularly generous when it comes to dividends which means that it makes up a
very large component of long term return the FTSE 100 Total Return Index is
the upper red line and the Total Return Index incorporates that dividend and you
can see that boosts the return from the lower to the upper red line and the FTSE 250 also gets a big boost from dividends in fact for FTSE 100 it more
than doubles the return from 3.1 percent to 7 percent over the last nine
years and for the FTSE 250 you get about a four percent boost now one of
the problems with small caps is that they don’t generate as much dividend
because if you’re trying to grow a company you plow your profits back into
the company to grow organically rather than paying it out to shareholders so
you rely on capital growth not dividend payments to generate your return and
although volatility wasn’t a good measure of risk looking at what happens
during a crisis gives you a better feel for why small caps are risky small caps
here are shown in blue and they lost about 60 percent of their value in the
credit crisis versus about 50% for the FTSE 250 and about 40% for the
FTSE 100 in the dot-com bubble between 2001 and 2003 the pain was felt
more evenly but you can see small caps still came off worst and in the latest
sell-off let’s call it Red October for 2018 it’s actually the FTSE 250 which
has sold off most so far now those were the indices you can’t actually buy an
index directly you have to buy fund which tracks the index so let’s take a
look at the small cap trackers unfortunately the selection of
exchange-traded funds which track the small cap market in the UK is limited to
one fund and this is managed by Blackrock under the iShares brand
and it tracks the MSCI UK small-cap index not the FTSE small-cap index
looking at that fund on Morningstar we can see why it’s so attractive the
long-term projected earnings growth is very high at 10% and over the long term
prices will track the earnings growth it’s a little bit surprising if you look
at the market capitalization breakdown of the fund because you can see that
more than half of them are medium caps not small caps it would simply be too
expensive to track those small cap indices [stocks] the management fee would be very
high so this fund’s been forced to shift the market cap into the mid cap range
and if we look at the MSCI UK small-cap index you can see the largest company
has a market cap of over 7 billion euros if we look where that lies on our graph
it goes well beyond the small caps which are the blue stocks on the left it eats
partially into the mid caps and it’s even encroaching into the large cap
region which is the red stocks which are in the FTSE 100 looking at the top 10
constituents of that index 5 of them are in the large cap FTSE 100 index four
are mid caps in the FTSE 250 and one of them is in the AIM index this tree
illustrates the correlation between different funds and indices the fund
we’re interested in is at the top and it’s ticker is CUKS and what you can
see is that it’s correlation is most tight with the FTSE 250 index tighter
in fact than its correlation with the FTSE SmallCap index at almost 95%
whereas it’s correlation with the small cap index is only 79% so if you’re going
to buy this fund be aware that it’s not just small caps you’ll also be buying a
very large slice of the FTSE 250 if you want richer pickings with the small
caps you’re going to have to go for global small cap funds two of the most
popular in the UK are the Vanguard global small-cap index fund which has
been around for a long time and the newcomer from Blackrock both track the
MSCI World SmallCap index and you can see that Blackrock has tried to steal
the market from Vanguard by having a very slightly lower ongoing
charge of 0.35% per year versus Vanguard’s 0.38% per year but notice that
this is much more than you’d pay for tracking a much more large and liquid
index like the FTSE 100 it’s always worth looking at the fund fact sheet
because this tells you the risks of owning the fund the first thing to see
is that it doesn’t buy all of the stocks in the index in order to reduce the
trading fee it only buys a subset of the securities that make up the index it
will avoid the least liquid ones and that will induce a tracking error it
won’t track the index perfectly in order to generate some revenue the stocks
which are bought by the fund manager will be lent out to other investors some
of that money will go to the fund manager Blackrock and some of it will be
used to reduce your fee don’t try to make short-term plays with this index
buy it and hold it for the long term because then you’ll get the most out of
it and because it’s global small caps its US dollar denominated that means you
take an additional currency risk of sterling versus the US dollar you should
also be aware that the name of the index which is the world small-cap index
actually refers to the developed world in the graph at the bottom you can see a
comparison of the total return with the ACWI small-cap index where AC stands
for all country and that includes emerging market stocks like China in the
bottom right you can see the country weights of the index and as with any
developed market stock index it’s dominated by the US which makes up about
60% of the index then we get Japan at 12% and the UK makes up only 7% of the index
if we compare returns over the last four years you can see the attraction of the
global small-cap index the annualized return has been considerably more than
UK small caps and far more than the FTSE 250 and the FTSE 100 which had just
returned a paltry four percent and 1 percent over the last four years a good
question is why small caps outperform and nobody knows the answer but this
guy’s opinion is definitely worth listening to
he’s Elroy Dimson and he’s emeritus professor of Finance at
in business school he’s also the co-author of a very widely read report
which looks at stock performance over a very long period and his comment here is
that the small cap effect seems to have faded in recent decades and if we were
to look at this factor for the first time now we’d only find a modest small
cap premium and in fact the reward you do get for small caps may simply be due to
the illiquidity risk you take by owning them and he also warns against the
higher management cost that you get when you have a small cap fund that’s the
price of trading something which is illiquid and this article from Vanguard in
the US picks up on that thought and it’s a brief dialogue between Frank
Chism who’s a senior product manager or marketer and the head of the
quantitative analysts is called Matthew Jiannino and you can think of a quant
as a nerd like me when the product group asks the quantitative equity group about
producing single factor funds they came up with a fairly standard list of
factors such as value and momentum but instead of saying small cap versus large
cap they said liquidity and the justification that the quants gave and
the justification that the quants gave was that many small cap fund managers
are just harvesting that liquidity premium and that’s why instead of small
cap versus large cap Vanguard produces funds which target low liquidity stocks
to harvest that liquidity premium and in the diagram in the bottom right
they show the liquidity continuum from the largest and most liquid market on
the planet which is for US government debt or T-bills then we go through
public equities and the sweet spot of liquidity which they point out is
between public equities and a combined category of real estate and private
equity Vanguard have produced both a US liquidity factor fund and a UK
liquidity factor fund in the UK you can buy the Vanguard global liquidity factor
exchange-traded fund the ticker’s VLIQ and I’ve done a whole video about that
Vanguard rank stocks within each regional group combines the scores to
form a composite and then buys the least liquid stocks according to that score
and they rebalance that portfolio on a regular basis and by doing that they
harvest this illiquidity premium the reason why this is
interesting is that it provides a cheaper way of getting exposure to the premium
you’re paid for owning small caps because the ongoing charge for VLIQ is
only 0.22% versus 0.35 or 0.38% for the global small-cap index so small
caps are like an amplified version of the overall market when times are good
and there’s a market rally they tend to be better than the overall market and if
there’s a crash they tend to suffer more so if you want them as part of your
portfolio you’ve got to be able to stomach that kind of up-and-down motion
otherwise you could end up getting burnt now if you enjoyed that and you find our
videos useful and many of you tell us that you do find them useful then please
consider supporting us on Patreon for just $5 a month or preferably $10 a
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10 comments on “Small Caps Versus Large Caps: Which Is Best?

  1. Thanks for the video, I still think for UK investors currency risk is currently the biggest risk we face.

    If alot of good news suddenly comes out regarding brexit and the GBP rallies it will crush UK investors who invested overseas.

    For that reason I dont feel confident putting money outside of UK at moment especially with pounds recent drop to 1.28

  2. Incredible video. I have been investing heavily in FTSE 250 for some years but I think I'm going to look more into small cap funds to boost my returns further.
    Thanks, Andy

  3. will be buying the vanguard global small cap had my eye on it for a while now that red October has happened can pick up a bargain

  4. Another informative vid again , PC! As a recent investor into the stock market your videos have been really enlightening. I did have a question though, I have been doing as much reading as possible and there seems to signs of a downwards trend looming in the market, now i'm in it for the long haul, however, would it be best to wait for the downturn to start pumping money in or is it just a case of dollar cost averaging and still invest? thanks

  5. Small caps do well when borrowing funds is cheaper. Which would explain why they struggled during periods of the 80's and 90's when interest rates were higher.

  6. I don’t quite understand 9:40 when you say you take an additional risk against the USD specifically as it is Dollar Denominated. Surely there is no ‘additional’ risk from it being denominated in USD. You are taking on the same risk against all currencies, just as if the fund was denominated in GBP. ?

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