In hard times, small is beautiful
Small-caps often fare poorly when markets are sluggish, but during the current crisis, larger companies have been hit the hardest. Could a wise, diversified investment in small companies yield better returns?
Good things come in small packages, as the saying goes. Does this also mean greater investment opportunities can now be found in smaller companies, rather than their larger counterparts? The answer is not unequivocal.
Historically, smaller companies’ shares have yielded better returns when the markets are soaring, as investors become less averse to risk-taking. On the other hand, bear markets typically hit these companies harder than larger ones.
This makes sense. Small-cap stocks entail more risks and respond sharply when these risks actually materialize. Larger, more stable companies in traditional industries such as commerce, services, industry and retail are less exposed to market fluctuations. Many of these companies manage to remain profitable even during hard times.
Smaller enterprises, on the other hand, tend to be less stable. They have less access to capital and financing opportunities, and are less able to withstand stormy financial times. Thus, in times of uncertainty, investing in them is more risky − and often not recommended.
However, the financial world is currently undergoing major changes. Former truisms may not be so in the future. The last few years have not been kind to larger companies. Many large banks and insurance companies throughout the Western world saw their share prices battered. Many strong companies that had borrowed money went into a tailspin. This was the case in Israel as well, with dire results for holding companies and real estate firms that had invested overseas.
Take a look at Israel’s financial markets over the last year. The Tel Aviv-100 Index gained 1%, while the banking index lost 21%. The MidCap-50 Index gained 12%. Meanwhile, in the United States, both the S&P 500 and the Russell 2000 index, which includes smaller companies, gained 18% to 20%, respectively.
In emerging markets, on the other hand, historical patterns reigned supreme. The MCSI index for emerging markets, as tracked by the EEM exchange-traded fund, dropped 5%, while the S&P small-cap index for emerging markets (as represented by the EWC ETF) lost 12%. The investment bank Morgan Stanley found that in recent years, emerging market small-cap indices had fewer fluctuations than had indices of larger companies. This was due to the fact that in emerging markets, smaller companies were exposed mainly to the local economies, which were expanding.
There is no uniform answer to the question of whether smaller or larger companies make better investments given the current market. The answer depends on the risk tolerance of the investor, his or her assessment of global market prospects, the specific market being considered and the relative costs of different shares. But there are several reasons to believe that, both locally and abroad, small-caps are likely to be attractive in the near future, despite their risks.
01 Disappointment with large-caps
Many large-cap companies have disappointed investors in recent years. Large international banks, which gave generous loans to real estate developers, are now finding themselves in severe financial trouble. They are still burdened by problematic mortgage debt, while their assets include government bonds issued by countries in financial distress, as well as bonds belonging to mortgage creditor companies. Banks in Israel are similarly over-exposed to real estate.
In the United States, veteran automakers General Motors and Chrysler went through Chapter 11 bankruptcy proceedings. In Israel, the shares of some of the country’s largest holding companies, including Africa Israel, Delek and the IDB group, collapsed. Cell phone service providers Cellcom and Partner took serious hits, and even telecommunications provider Bezeq saw its shares drop by 32% in one year.
Investors, feeling that these large and stable companies had let them down, reassessed and realized their risks might be higher than previously thought.
02 Technology shares
Last year pushed a number of technology companies, several of which are still quite small, into the limelight. In Israel, new stars Mellanox Technologies and Babylon did particularly well; shares in each company gained 275%. Retalix, EZchip and Allot Communications also rose sharply. American technology companies also have been doing very well, despite the gloomy markets.
The economic slowdown is mostly bypassing these companies, since they operate in niches that are still growing. Not all of these companies will be successful, and some are trading at highly inflated valuations, but overall the future bodes well for them. Furthermore, many of these companies have cash reserves, and therefore are not dependent on raising capital or borrowing money. This makes them less vulnerable to the credit restrictions prevalent in today’s markets.
03 Changing markets
In mature markets, which change slowly, bigger companies have an advantage over smaller ones. Their larger scale of operations enables greater efficiency. However, when the rules of the game change, these companies find it harder to adapt. This was evident in Israel’s communications sector over the past year, as upstarts Rami Levi Communications and Golan Telecom snatched customers away from the veteran cell phone companies. A similar development took place among supermarkets, as veteran chains Super-Sol and Mega were undercut by smaller discount chains such as Rami Levi Shivuk Hashikma, Victory and A.R. Zim.
04 Preference for local economies
In recent years, larger American companies benefited from the weak U.S. dollar, which boosted their profits in European and emerging markets. Over the last year, though, the dollar has strengthened against other currencies, cutting into these profits. In contrast, smaller companies that operate only within the United States and depend more on imports benefited from the strengthening dollar.
Exposure to overseas markets is usually advantageous for large companies over the long term. However, in the near and mid-term, with European and Asian markets slowing down, less international exposure may be beneficial. The U.S. market will eventually feel this slowdown as well.
05 Avoiding individual stocks
Investing in small-cap shares generally forces investors to diversify. Outlier shares often play an outsize role in the fate of large-cap indices. Thus, for example, every dollar invested in the NASDAQ 100 via the QQQ ETF fund is actually a $0.19 investment in Apple, $0.08 in Microsoft and $0.05 in Google − one third of the total investment. If you invest in the Dow Jones index through the DIA ETF fund, 30% of your money is actually invested in six large companies: IBM, McDonald’s, Exxon Mobil, Chevron, 3M and Caterpillar.
In contrast, investing in the Russell 2000 index through the IWM ETF gives a much more diversified portfolio. The portfolio’s largest holding in an individual company is only 0.3% of the total. This broad distribution reduces the risks, and lessens the portfolio’s dependence on a handful of leading stocks.
06 More potential for growth
Many of the arguments around investing in small-cap companies assume the global economy will worsen. While this is a reasonable assumption, it is not a given − things may actually improve. The U.S. real estate market is showing signs of recovery, and emerging markets are still growing, despite the current slowdown. Even in Europe, signs of improvement are apparent in some countries, especially in Eastern Europe.
Should a recovery take place, smaller companies often have a better potential for share growth, and far-sighted investors can benefit from this.
This is a less likely scenario, but it should not be ruled out.
07 More choices
There’s a very broad range of small-cap companies. While the S&P 500 contains 500 leading stocks, the U.S. market has thousands more, belonging to companies that diverge widely in size and character. In Israel, too, there are hundreds of publicly held companies that are not listed on the TA-100 Index. Anyone with the time or inclination to dig could find great opportunities among the smaller companies. This is no easy task, but some like the challenge.
Most investors aren’t interested in this kind of search, so they invest in small-caps through mutual funds or ETFs. Here the choices are more limited. Choosing the wrong fund on the Tel Aviv Stock Exchange would have lost an investor 9% last year, while the leading fund would have earned him 7%. Since it is very difficult to choose the right fund, a possible strategy might be to split an investment among different funds.
And the disadvantages
Along with the advantages of investing in small companies, there is one well-known disadvantage: higher risk. Many small companies, especially in the technology sector, do not distribute dividends. Some of them have only minimal, fragile profits. Many have low trading volume, and a slide in the markets could batter their value. A prolonged recession could also prove deadly. During such periods, many small companies go under due to their limited access to financing.
A further disadvantage is that some small-caps are quite expensive. Some of these companies, especially in the technology sector, are growing fast and are already trading at prices that reflect optimistic forecasts. Should their performance disappoint, their shares could plummet.