It's the Little Things: Why US Small-Cap Stocks Deserve More Attention

For most investors, a primary objective is creating an optimal portfolio allocation that maximizes returns for a given level of risk. When designing portfolios, investors might consider various things such as allocating to mixed asset classes, different types of securities or geographies. Key considerations will likely include historical performance, correlation of returns, and volatility.

Key Benefits of Small-Cap Investing:

• Inefficiency – the small-cap universe is typically far less thoroughly researched than large-caps as illustrated in the charts below. The relative lack of analyst coverage can contribute to mispricing that creates potential opportunities – that is, without experts actively evaluating a stock, shares can diverge from their fair value.
• The power of stock-picking – with over 2,000 companies to choose from in the US alone, active managers can dig deep to identify promising growth stories or undervalued opportunities that may be overlooked by the broader market.
• Specialization – managers and research analysts who focus on this area develop the expertise needed to uncover specific sectors, industries or geographic niches that may be under-represented in small-cap indexes. For example, an analyst might specialize in software companies or emerging biotechs. This can help identify promising opportunities that others may overlook or misunderstand.

Demystifying Small-Caps

Small-cap investing has a rich history that spans decades and reflects the evolution of financial markets and investment strategies. In the US, small-cap stocks typically represent companies with a total market capitalization ranging between $300 million and several billion dollars.

The history of small-cap investing is blurry, but a significant moment came in the post-World War II era with the rise of mutual funds and the advent of portfolio diversification theories, such as Harry Markowitz’s Modern Portfolio Theory in the 1950s. This led to a greater appreciation for the role of small-cap stocks in achieving benefits derived from a diversified portfolio.

The introduction of the Russell 2000® Index in the 1980s marked a big step forward for small-cap companies and made it easier for investors to gain exposure. Since then, the increased availability of data and advancements in technology has made it possible for investors to conduct more thorough research and analysis.

The Small-Cap Opportunity

Put simply, the universe of small-cap companies covers a wide breadth of sectors, industries and factors compared to the relatively narrow large-cap market which is dwarfed by a few enormous organisations. Exploring these smaller companies could provide early access to the successful businesses that will likely make up the future mid and large-cap universe.

The host of opportunities in this space opens a range of complementary dimensions for investors. The advantages of carving out space for small-cap companies in a portfolio start to become obvious. For example:

1) The diversification boost – this seems straightforward. Why restrict a portfolio to large-cap stocks when the opportunities are far wider? It could even be argued that the lower correlation between small-and large-cap stocks improves overall portfolio efficiency. Put simply, small-cap companies behave differently (for example, they are often nimbler and can react faster to change), providing diversification.

2) Small-caps, big growth – smaller companies tend to grow revenues and earnings faster than their larger counterparts. Investing in these companies early in their life cycle could therefore provide more upside. In other words, the expansion opportunity is greater.

3) Spanning the economic landscape – we have already acknowledged the much larger number of companies available to invest in versus the large-cap space. Add to that fact that the breadth of sectors that small-cap companies span is wider than their large-cap counterparts who are typically concentrated in sectors like technology as the chart below demonstrates.

Source: Factset as of 08/31/2023. Sectors are based on the Global Industry Classification Standard (GICS) classification system.

Balancing the Risks and Rewards

Of course, with opportunity, comes risk and balancing the two takes expertise.

In this case, the smaller size of these firms compared to their large-cap counterparts introduces higher idiosyncratic risk, or the risk associated with the individual investment in a company. Examples might include the impact of a management team’s decisions, the culture of an organisation, new competitors, or a change in a legal framework.

Liquidity risk is another key area to consider. Low trading volumes can lead to wider bid-ask spreads and difficulties exiting positions. Other issues like crowded trades can exacerbate liquidity challenges and result in higher share price volatility.

Finally, due to a lack of analyst lack coverage, there is generally less availability of information than might typically be seen in larger cap companies.

All of this can result in higher volatility and requires a higher appetite for risk. But for patient investors, the results could be worth waiting for as the charts highlight below. To achieve this, active managers, supported by specialist research teams are key to mitigating the risks, selecting the best opportunities and taking advantage of any volatility for an attractive entry point. Implementation requires diligent security selection and risk management – an important reason for a rigorous investment philosophy and process.

The Active Advantage

Skilled active small-cap managers can add alpha by exploiting their experience, their deep research and sticking to their investment process in different market environments. There are various opportunities that investors can exploit to generate alpha in this space:

• Inefficiency – the small-cap universe is typically far less thoroughly researched than large-caps as illustrated in the charts below. The relative lack of analyst coverage can contribute to mispricing that creates potential opportunities – that is, without experts actively evaluating a stock, shares can diverge from their fair value.
• The power of stock-picking – with over 2,000 companies to choose from in the US alone, active managers can dig deep to identify promising growth stories or undervalued opportunities that may be overlooked by the broader market.
• Specialization – managers and research analysts who focus on this area develop the expertise needed to uncover specific sectors, industries or geographic niches that may be under-represented in small-cap indexes. For example, an analyst might specialize in software companies or emerging biotechs. This can help identify promising opportunities that others may overlook or misunderstand.

America’s Small-Cap Advantage

A dedicated US small-cap mandate with high active share, focused on high-quality companies and mitigating downside risks, may enable investors to capitalize on the long-term potential found in US small-cap equities.

• US-based smaller companies include an exciting and dynamic group of growing businesses that typically demonstrate high innovation and strong entrepreneurial cultures.
• Over half of global smaller companies – more than 2,000 companies – are listed in the US, creating a huge opportunity.
• US smaller companies offer a deep and liquid market but are typically not as well covered by sell-side research analysts as their larger counterparts, creating inefficiencies and missed opportunities that can be exploited.
• A US stock market listing means there are high governance hurdles relative to their global peers, considerably reducing the risk profile of US smaller companies.

Levering Experience and Expertise

Brown Advisory has been investing in small, medium and large-sized companies in the US for over 25 years. Across its range of small-cap strategies, it manages approximately $9bn on behalf of institutional and intermediary clients as well as high net worth individuals. Clients benefit from Brown Advisory’s extensive research capabilities with a large team who cover the entire US market – analysing different sized companies (as they grow) and how they interact with one another across the spectrum. Alongside this, the firm benefits from an extensive network of venture capital, private equity and corporate relationships . Understanding the full spectrum of private and public companies is of fundamental importance to not only have a full picture of the competitive landscape but also to have access to the companies that might be likely to float in the future.

Brown Advisory believes that disciplined, bottom-up research, coupled with collaborative teamwork and the free exchange of ideas amongst colleagues, are the keys to achieving long-term outperformance. The combination of its investment philosophy and its client-first culture helps to make Brown Advisory a compelling portfolio manager.

In Summary

Offering diversification, growth potential, and a breadth of opportunities, in our view, small-caps deserve serious portfolio consideration - while individually small, collectively they account for nearly 3/4 of all U.S. listed companies across a diverse mix of sectors . Though sometimes neglected, this niche allows skilled active managers to unlock overlooked value. Despite higher risks, a modest small-cap allocation can enhance portfolio efficiency for patient, long-term investors aiming to boost returns.