Lazard Insights Capturing the Small-Cap Effect Edward Rosenfeld, Director, Portfolio Manager/Analyst Summary Historically, small-cap equities have outperformed large-cap equities across several regions. This is a well-known capital markets phenomenon sustained by empirical studies. Active managers within the small-cap universe have historically been able to deliver a more uniform and consistent record beating their benchmark relative to their large-cap peers. The breadth, depth, and composition of the small-cap equity universe differ considerably from large cap. This has important implications for interpreting valuations, and how managers approach the opportunity set. Globally, the small-cap opportunity set is vast and, at the same time, thinly covered by analysts. As such, we believe the asset class remains fertile ground for active stock selection yet requiring a particular skill set. In our view, the principal skill needed in small caps includes assessing the capital allocation track record of company managements, by evaluating the returns-based discipline and the management teams incentives. Lazard Insights is an ongoing series designed to share valueadded insights from Lazard s thought leaders around the world and is not specific to any Lazard product or service. This paper is published in conjunction with a presentation featuring the author. The original recording can be accessed via www.lazardnet.com. The Small-Cap Effect Academic studies have demonstrated that small-cap equities have outperformed large-cap equities. 1 Small-cap outperformance is consistent across the globe and its effects compound over time. The small-cap premium, when multiplied throughout decades, frequently allows small-cap equities to markedly outperform large-cap equities. For instance, from December 1999 to June 215, the MSCI World Small Cap Index (+26%) has outperformed the MSCI World Index (+6%) by nearly 2% in aggregate (Exhibit 1). Furthermore, smallcap outperformance is consistent throughout time and is not the result Exhibit 1 Global Small-Cap Equities Have Significantly Outperformed Large Caps in Aggregate Since 1999 Index, 1 = December 1999 4 2 1 21 2 25 MSCI World Small Cap Index 27 MSCI World Index 29 211 21 215 For the period December 1999 to June 215 All data in USD based on total return (net) indices. The performance quoted represents past performance. Past performance does not guarantee future results. Not intended to represent any product or strategy managed by Lazard. It is not possible to invest directly in an index. Source: MSCI, Haver Analytics
2 of just one or two outsized years or biased toward a given start date, as evidenced by analyzing rolling periods. Over the last fifteen years, on a rolling one-year basis, small caps outperformed large caps 67% of the time. Over three- and five-year rolling periods small caps outperformed large caps in 8% and 96% of the time, respectively (Exhibit 2). With this in mind, a small-cap allocation can be rewarding, especially for investors with longer time horizons. Active Management in Small Caps Small-cap outperformance historically has been enhanced by an active stock selection approach. Furthermore, small-cap active managers appear to have a better record of adding value than their large-cap counterparts. Exhibit displays the results of a recent academic study (Mason et al. 215) that shows the degree to which small-cap active managers have added alpha versus their corresponding style benchmarks. 2 From 199 to 211, small-cap growth, blend, and value funds have outperformed their benchmarks by approximately 4,, and 2 basis points (bps) respectively, on a monthly basis gross of fees (net of fee results are also positive). This alpha is even more impressive when compared to large- and mid-cap strategies. Large-cap growth, blend, and value funds only added approximately 1, 2, and 5 bps of alpha on a monthly basis during the same time period. Over time, small-cap active managers have been able to deliver a more uniform and consistent record of beating the benchmark than large-cap portfolio managers. While the academic study referenced in Exhibit strictly focused on the US equity mutual fund universe, we conducted our own research to investigate the results of international active small-cap managers. In Exhibit 4 (page ), the left panel shows that international smallcap managers have added significantly more value over time than US small-cap managers. The right panel shows that international small-cap managers consistently posted better excess returns than international large-cap managers. Therefore, these results suggest that actively managed small-cap strategies have the potential to add even more outperformance Exhibit 2 Small-Cap Allocations Can Be Rewarding for Long-Term Investors, December 1999 June 215 Rolling Five-Year Annualized Return MSCI World Small Cap (%) 2 1 Points above the diagonal indicate Small-Cap outperformance -1-6 6 12 18 24 MSCI World (%) Months Months of SC Outperformance % of Months Rolling 1-Year 175 118 67.4 Rolling -Year 151 126 8.4 Rolling 5-Year 127 122 96.1 As of June 215 All data in USD based on total return (net) indices, monthly frequency. The performance quoted represents past performance. Past performance does not guarantee future results. Not intended to represent any product or strategy managed by Lazard. It is not possible to invest directly in an index. Source: MSCI, Haver Analytics to the baseline small-cap effect (international small-cap strategies appear stronger in this sample). Small Cap and Large Cap Are Very Different Opportunity Sets The investable universes where small- and large-cap managers operate have significant disparities. These differences inform why, on balance, small-cap portfolios have posted more favorable results. For starters, Exhibit Small-Cap Active Managers Have Historically Added More Alpha than Large-Cap Managers US Equity Mutual Fund Groups, 199 211 Monthly Alpha versus Russell Style Indices (%).4 Gross Net. Small-Cap Funds.2.1. -.1 Large-Cap Growth Large-Cap Blend Large-Cap Value Mid-Cap Growth Mid-Cap Blend Mid-Cap Value Small-Cap Growth Small-Cap Blend Small-Cap Value Size and Style criteria are defined by Morningstar. Alpha calculated as regression of monthly returns for each equal-weighted group versus the corresponding Russell style index. Number of funds for each category: large-cap growth (89), large-cap blend (488), large-cap value (52), mid-cap growth (25), mid-cap blend (166), mid-cap value (155), small-cap growth (244), small-cap blend (19), small-cap value (147). Total 2,84 funds. The performance quoted represents past performance. Past performance does not guarantee future results. Not intended to represent any product or strategy managed by Lazard. Source: Mason, Andrew et al. On luck versus skill when performance benchmarks are style consistent. Working Paper, April 215, Table D
Exhibit 4 International Small-Cap Managers Have Added More Alpha than US Small-Cap and International Large-Cap Managers Universe Average Excess Returns (%) 4 US Small Cap International Small Cap (%) 4 International Large Cap International Small Cap 2 2 1 1 1 Year Years 5 Years 1 Years 1 Year Years 5 Years 1 Years As of June 215 Data are excess gross returns based on evestment manager universes: US Small Cap, 672 managers; International Small Cap, 75 managers; International Large Cap, 24 managers. Excess return is calculated versus the manager s preferred benchmark as defined in evestment. Periods greater than one year are annualized. The performance quoted represents past performance. Past performance does not guarantee future results. Not intended to represent any product or strategy managed by Lazard. Source: evestment global small-cap managers have a much larger investable universe than global large-cap managers the MSCI World Small Cap Index has 4,265 constituents, dwarfing that of the MSCI World Index s 1,645 constituents. With nearly three times as many companies in the index, small-cap managers have a much wider opportunity set than their large-cap counterparts. (Benchmark data in this section are as of June 215 from MSCI). Exhibit 5 The Small-Cap Opportunity Set is Constantly Evolving # of Companies 66 44 Not surprisingly, the average and median market cap in the small-cap benchmark is lower. But what is perhaps more striking is the long tail of companies below $1 billion in market cap: The median market cap for the small-cap index is $772M, meaning that 5% (approximately 2,1 stocks) are below this level. Additionally, small-cap managers have a much more diffuse index than large-cap managers. The top ten stocks in the large-cap benchmark make up a significant, nearly 1%, weight in the index, while the top ten constituents of the small-cap index combine for a fairly immaterial 1.4% weighting. 22 29 21 MSCI World Adds MSCI World Deletes 211 212 21 214 MSCI World Small Cap Adds MSCI World Small Cap Deletes As of 1 July 215 A given company may be added and deleted in the same period. Source: MSCI, FactSet July 215 It is also important to note the differences in terms of sector composition between the small- and large-cap indices. Valuations oscillate and, at different points in time, one asset class can seem much more attractively valued than the other. However, valuation comparisons can be misleading when made between asset classes, especially without considering additional details. The small-cap index is composed of a much higher weighting of cyclical categories, such as the consumer discretionary, industrials, and information technology sectors, while the large-cap index has a significantly higher weighting in the defensive sectors, such as the health care, consumer staples, and utilities sectors. This asymmetry allows the small-cap asset class to exhibit faster sales and earnings growth than large caps in a rising and improving economy. The defensive sectors of large-cap indices are populated with former growth companies, and some may have regulated or capped returns. These low-multiple companies are scarcely present in small-cap indices. Furthermore, the different composition of the indices leads to different valuations, which often causes uninformed observers to comment that smallcap stocks are expensive compared to large caps, when in reality, small-cap stocks offer a different growth profile and cyclicality versus large-cap stocks. Small-cap indices have many more early-stage companies that are still unprofitable, which would tilt the scales in favor of large-cap indices in any comparison of earnings-based metrics. Another notable feature of the small-cap asset class is the active changes in the opportunity set (Exhibit 5). In addition to thousands of companies available for small-cap investors, the opportunity is very dynamic. The small-cap asset class is rapidly changing as hundreds of securities are entering or exiting the benchmarks each year due to a variety of factors, including initial public offerings, spin-offs, marketcap graduations, bankruptcies, and merger-and-acquisition activity.
4 Exhibit 6 Small-Cap Companies Performance Varies More than Large-Cap Companies Spread of +/- One Standard Dev. Range: MSCI World Small Cap Index Minus MSCI World Index -Year EPS Growth (%) 16 P/E 4 12 8 4 2 211 212 21 214 215 1 211 212 21 214 215 ROE (%) FCF Yield (%). 9 1.5 7. -1.5 5 -. 211 212 21 214 215 211 212 21 214 215 As of June 215 All data in USD and quarterly frequency. P/E and ROE are forward 12-month data. For P/E, ROE, and FCF yield calculations we excluded the top/bottom 1% of values each quarter to control for impractical extreme values. Source: Compustat, Worldscope, IBES, MSCI, FactSet In general, small-cap companies also have a more varied record of corporate performance than large cap companies. Exhibit 6 illustrates the spread in the range of standard deviation for several investment characteristics including earnings-per-share growth, valuations, profitability, and free-cash-flow yield. There is a higher level of dispersion in the small-cap universe than that of the more uniform large cap opportunity set. In three of the four metrics the higher dispersion is consistent over the entire time period, with return on equity (ROE) being the lone exception. Given what we have discussed thus far, we can conclude that small cap managers have an extremely wide opportunity set, the asset class itself is dynamic, and that there is a tremendous dispersion in terms of quality and valuation within this opportunity set. Therefore, it seems reasonable to conclude that a somewhat different skill set is needed to successful investing in small caps as compared to large caps, which we will address next. A Specific Skill Set Is Needed Given the breadth and depth of the small-cap asset class, we believe a dedicated team is needed in order to adequately cover the universe. At the beginning stages of the investment process, a generalist approach may be sufficient since many small-cap business models are frequently straightforward and their corporate structures are typically not overly complex. Assessing the capital allocation discipline of companies managements, as well as their overall governance and incentive structure alignment is possibly the most important skill for small-cap portfolio managers. Small-cap companies are more malleable and corporate managements often have a larger influence on their company s fortune, strategies, and outcomes than larger, more bureaucratic institutions with several layers of management. In addition, small-cap management teams may not necessarily have the best interests of all shareholders in mind as some run their companies as lifestyle enterprises. Thus, in an asset class where management quality and skill vary greatly we believe a disciplined, measured, and consistent approach to evaluating small-cap companies managements is essential. More than a third of the small-cap universe has no sell-side research coverage and the average number of sell-side analysts per stock is only.6 (Exhibit 7, page 5). To put this in perspective, the typical large-cap stock is covered by 2 or 24 analysts. With less information available, many market participants may exclude small caps from their model portfolio opportunity sets because they may not be able to accurately assess the risks. The combination of a larger opportunity set that has less sell side analyst coverage provides active managers with more opportunity to find value and to uncover hidden gems. As a result, buy side practitioners need to engage in more primary research in this asset class, but the reward is commensurate with the effort.
5 Exhibit 7 Small Caps Are Not Well Covered by the Sell Side 42 28 14 Average # of Analysts Covering % of Companies without Analyst Coverage 2.5. Large-Cap Companies (> $2B) 16.5.1 Mid-Cap Companies ($5B $2B).6 5.2 Small-Cap Companies (< $5B) As of June 215 Universe is MSCI World All Cap (Large/Mid + Small Cap + Micro Cap) and may include more than one share class for certain companies. Market cap is float-adjusted MSCI value. Estimates reflect count of analysts offering EPS estimates for nearest unreported fiscal y-end as of June 215. Source: MSCI, FactSet Exhibit 8 A Good Capital Allocation Track Record and Cheap Valuations Have Historically Been Rewarded ROE and P/E Quintiles for the MSCI World Small Cap Index, June 25 June 215 Annualized Return (%) 15 1 5 PE ROE As previously mentioned, assessing the capital discipline track record of companies is essential when analyzing small-cap companies. Through back testing, we have determined a robust relationship exists between a company s valuation, financial productivity, and the subsequent stock market returns. Exhibit 8 shows the results of dividing the small-cap universe into five buckets (quintiles). Each bucket has a descending category of financial productivity, as measured by forward ROE, and ascending valuation, as measured by forward priceto-earnings ratios. We believe there is a clear relationship between a company s financial productivity and its market returns, and a company s valuation and its market returns. Ideally, in order for investors to successfully select small-cap stocks, they should look for cheap companies that have high ROE. Conclusion The favorable historical outperformance of small caps over large caps is a well-established phenomenon of the capital markets, which has also rewarded active management. Globally, the small-cap opportunity set is vast and at the same time is thinly covered by analysts. As such, we believe the asset class remains a fertile ground for active stock pickers. The structure of the small-cap equity opportunity set differs significantly from that of large caps. Small caps represent a wider opportunity set with non-uniform expertise from company managements which translates to more dispersion in overall investment characteristics. In this setting, we believe specialist teams that exhibit screening acumen as well as the discernment to evaluate the capital allocation framework of the company s managements, stand to benefit from the small-cap premium. Quintile: 1 High ROE Low P/E 2 4 5 Low ROE High P/E As of June 215 For ROE, quintile one corresponds to the highest ROE, in the case of P/E, quintile 1 is the lowest P/E. ROE and P/E are forward 12-month. The performance quoted represents past performance. Past performance does not guarantee future results. Not intended to represent any product or strategy managed by Lazard. It is not possible to invest directly in an index. Source: Bloomberg
6 Notes 1 Banz, Rolf. The Relationship Between Return and Market Value of Common Stocks. Journal of Financial Economics, 1981. Fama, Eugene F. and Kenneth R. French. The Cross-Section of Expected Stock Returns. The Journal of Finance, June 1992. Asness, Cliff. The Small-Firm Effect Is Real, and It s Spectacular. AQR Capital Management, Cliff s Perspective, January 215. 2 Mason, Andrew et al. On luck versus skill when performance benchmarks are style consistent. Working Paper, April 215. The goal of this study was to contrast the use of investable style benchmarks rather than academic factors to assess managers performance. Important Information Published on 15 September 217. This document reflects the views of Lazard Asset Management LLC or its affiliates ( Lazard ) based upon information believed to be reliable as of 26 August 215. There is no guarantee that any forecast or opinion will be realized. This document is provided by Lazard Asset Management LLC or its affiliates ( Lazard ) for informational purposes only. Nothing herein constitutes investment advice or a recommendation relating to any security, commodity, derivative, investment management service or investment product. Investments in securities, derivatives, and commodities involve risk, will fluctuate in price, and may result in losses. Certain assets held in Lazard s investment portfolios, in particular alternative investment portfolios, can involve high degrees of risk and volatility when compared to other assets. Similarly, certain assets held in Lazard s investment portfolios may trade in less liquid or efficient markets, which can affect investment performance. Past performance does not guarantee future results. The views expressed herein are subject to change, and may differ from the views of other Lazard investment professionals. This document is intended only for persons residing in jurisdictions where its distribution or availability is consistent with local laws and Lazard s local regulatory authorizations. Please visit www.lazardassetmanagement.com/globaldisclosure for the specific Lazard entities that have issued this document and the scope of their authorized activities. Equity securities will fluctuate in price; the value of your investment will thus fluctuate, and this may result in a loss. Securities in certain non-domestic countries may be less liquid, more volatile, and less subject to governmental supervision than in one s home market. The values of these securities may be affected by changes in currency rates, application of a country s specific tax laws, changes in government administration, and economic and monetary policy. Small- and mid-capitalization stocks may be subject to higher degrees of risk, their earnings may be less predictable, their prices more volatile, and their liquidity less than that of large-capitalization or more established companies securities. RD199