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Long-term returns data compelling, but systemic approach to small caps required

Small cap investing has considerable upside, which the long-term returns data shows. But many small caps are less than quality grade, and the managers picking them can be rife with bias.
Equities

Small cap portfolio managers are doing a fine job, insists Invesco senior portfolio manager Andre Roberts. The results speak for themselves, he told a room full of advisers and consultants; over the long term small cap active management delivers alpha at a rate that puts the sector in the top quartile.

But it’s what small cap managers do wrong, and what approaches they can take to ameliorate those flaws, that interests Roberts.

“There are a lot of orthodox wisdoms about small cap management that people just accepted truths without really challenging,” he said at The Inside Network’s Growth Symposium in Sydney. “Managers are doing a good job, but as a systematic manager I just see areas for improvement.”

  • Attributes perceived as strengths, such as industry specialisation, or “sweet spots”, can often inhibit diversification, Roberts (pictured, left) explained. “In a small cap portfolio you often see style preferences exhibited over quality.”

    Those sweet spots create blind spots in other areas, too.

    “Liquidity is a real challenge in a small cap portfolio, and sometimes there’ll be hugely illiquid positions in companies that can be traps,” Roberts said. “And it’s not unusual to see some behavioral biases being displayed, with [portfolio managers] having favorite names. They love to hang on to these stocks…”

    Overconfidence bias is also rife in the sector, he explained, with small cap managers prone to the same behavioural finance flaws as any retail investor. In the same way 94 per cent of men think of themselves as about average drivers, Dutch researchers DKW found that 74 per cent of fund managers globally believe they’re better than average at their job. “Now, it’s not unusual to see a bit of overconfidence with fund managers,” he said. “But you can imagine what the outcome of that would be.”

    To alleviate these biases, Roberts asserted, a quantitative approach can be adopted so that managers can lean on data to make rational, risk-adjusted choices.

    “You want to seek alternative views, views that are not necessarily in agreeance with yourself. And just be aware of some of the behavioral biases that finance research might have highlighted, things like seeking confirmation to your own views, and pandering to those privately without being open to new ones. Or you can let the data drive your investment decisions.”

    Behind the data

    Also on the panel, Fairlight Asset Management partner Nick Cregan (pictured, right) highlighted some of the data on quality investing in recent times to show that while it may have underperformed recently, the approach is a solid one in the long term.

    Hunting quality companies as an investment style consistently outperforms the world index, he said, coming on top 61 per cent of the time by an average of 2.7 per cent between 1981 and 2022 according to data from MSCI researcher Factset.

    Quality beats value-style investing 59 per cent of the time by an average of 2.5 per cent, he noted, and growth investing 63 per cent of the time by an average of 2.8 per cent.

    The consolidated figures pitch quality in even better light, he continued. The annual return for quality investments over the period is 12.2 per cent, compared to 9.5 per cent for the index, 9 per cent for growth and 9.8 per cent for value.

    There are nuances to the equation, however. Small cap stocks have what Cregan called a “quality problem”, with not enough quality distribution among the smaller stocks. Roughly 30 per cent of small stocks are classified as ‘junk’, while the figure for the biggest stocks hovers below 10 per cent.

    Despite its strong long term run, quality also underperformed drastically in 2022, Cregan noted. But advisers would do well to pay attention to the long term trend.

    “2022 wasn’t exactly a banner year for quality investing,” he said. “It was the worst year in history going back to 1982, if you put quality against value. But again, that consistency through time has been close to 60 per cent and that signal is very, very strong in terms of excess returns.

    “I think as investors, we said it would get a 60 per cent hit rate on our business investments would probably take that,” he said.

    Staff Writer


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