The Small Cap Amplifier
Microcaps offer a magnified dose of the size premium.
By: Brian Chingono and Dan Rasmussen
Over the first eight decades of recorded US stock market history, from 1926 to 2007, small caps outperformed large firms by a robust 2.5% annualized. The size premium was even stronger among microcaps, which outpaced large firms by 3.2% annualized. Therefore, allocating to microcaps provided incremental value to owning the small cap index, with microcaps delivering an additional 0.7% of return per year.
But the opposite outcome occurred after the Great Financial Crisis, as the size and value factors inverted for more than a decade. Over the 17 years since 2007, small caps lagged large firms by -3.4% annualized and this has been more pronounced among microcaps, which lagged large firms by -5.9% annualized. Based on the past 17 years, one might question the value-add of a microcap allocation as it has lagged the small cap index by -2.5% annualized.
Figure 1: Long Term Returns of Small and Micro Caps in the US (1926 – 2024)
Source: Ken French data library
What is most readily apparent from the chart above is that microcaps offer an amplified dose of the size premium. When small caps outpace large caps, microcaps extend the margin of outperformance. And when small caps trail large firms, microcaps lag by a wider margin.
But perhaps something has changed since 2007. Could there be something fundamentally broken about microcaps that will persist going forward? To answer this question, we looked at the global performance of microcaps relative to small caps since 2007. The chart below shows the indexed dollar premium of microcaps over small caps across developed regions over the past 17 years. Evidently, a “broken engine” hypothesis for recent microcap underperformance would have to explain why the microcap engine has continued to work as expected in Japan but is somehow broken in the US and Europe.
Figure 2: Indexed Dollar Premium of Micro Caps over Small Caps (1926 – 2024)
Source: MSCI
While microcaps have outperformed in Japan over the past 17 years, it should be noted that 2024 is an exception, with Japanese microcaps trailing the small cap universe by -6.1% in Q3 and -3.1% over the year-to-date period through September 2024.
Given the overall evidence spanning 17 years, we think a more likely explanation is investors’ recent preference for growth firms. As shown in the table below, value has trailed growth since 2007 in the US and Europe, in sharp contrast to the long-term value premiums before 2007. But similar to the picture we saw above, Japan stands apart as value has continued to outperform growth since 2007.
Figure 3: Annualized Value Premiums in Developed Regions
Source: Ken French data library
For the US and Europe, the connection between negative size premiums and negative value premiums in recent years is apparent in the relative sector weights between large and small caps. Relative to small caps, large US firms are massively overweight technology, and European large caps are significantly overweight pharmaceuticals. Both of these large cap overweights (i.e., small cap underweights) are growth sectors.
The technology and pharmaceutical industries have produced some of the most notable innovations over the past two decades. And these innovations have boosted the earnings of technology and pharma companies, attracting more investor capital to large caps at the expense of small caps in the US and Europe. In contrast, the MSCI Japan Large Cap Index looks pretty similar to its small cap peers in terms of sector allocation, with no sector difference above 8 percentage points. Notably, the biggest sector allocation in both the Japan Large Cap Index and the Japan Small Cap Index is to industrial firms, at around 25% and 27% respectively. While there is variation within each sector, industrials typically represent traditional value firms. Therefore, it appears there is less incentive for fund flows to favor large caps based on sector preferences in Japan. The chart below shows the difference in sector allocations between large and small caps in each region. Extreme imbalances of 10 percentage points or more are highlighted.
Figure 4: Difference in Sector Allocations Between Large and Small Caps (Sep 2024)
Source: MSCI
Overweighting high-expectation sectors also comes with higher prices, as shown in the chart below for the US and Europe, where the biggest sector imbalances exist today. Based on consensus analyst estimates, we measure a sector’s “expectation premium” as the median three-year EBIT growth forecast for that sector minus the median three-year EBIT growth forecast for the overall market. This expectation premium shows how much faster a sector is expected to grow relative to the market. And we measure the valuation premium of each sector as the percentage difference between a sector’s median Price/Book and the market’s overall P/B. As before, sectors with an extreme weighting imbalance in large caps relative to small caps are highlighted. In the Unites States, large caps are massively overweight (and small caps are similarly underweight) the technology sector, which is expected to grow earnings a rate that is 3.6 percentage points faster than the overall market. In anticipation of this excess growth, valuations in the US technology sector are 82% higher than the overall market. Similarly, European large caps are significantly overweight pharmaceuticals as the health care sector is expected to grow earnings 3.3 percentage points faster than the market, resulting in a valuation premium of 88%.
Figure 5: High and Low Expectation Sectors in the US and Europe (Oct 2024)
Source: S&P Capital IQ
Looking forward, a key question will be whether the expensive sectors overweighted by US and European large caps will continue to beat earnings expectations. Conversely, any positive surprises among cheaper sectors could disproportionately benefit small caps. As shown in the chart below, valuations are substantially cheaper among small caps, and microcaps offer additional discounts relative to the small cap index.
Figure 6: Median Price/Book Valuations by Size Category (Oct 2024)
Source: S&P Capital IQ. Large caps are defined as firms comprising the top 85% of aggregate market capitalization in each region. Small caps represent firms in the bottom 15% of aggregate market capitalization, with at least $100M in size. Micro caps are defined as firms in the bottom 5% of aggregate market capitalization, with at least $25M in size.
If today’s sector imbalances in the US and Europe begin to normalize going forward, we would expect small caps to benefit from a recovery in the cheaper sectors that are overrepresented among small firms. And since microcaps offer an amplified version of the small size premium, we could expect microcaps to outperform again once the size premium in the US and Europe turns positive.