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June 1, 2017

Should you include small cap stocks in your portfolio?

Most investors prefer large cap stocks in their portfolio for their perceived lower risk profile. The most popular indices for German investors are the DAX and Euro Stoxx 50 which include only the largest companies. But is it true that these blue chips are more stable or is it just another investor myth?

Stability is not automatically a question of size

If large caps are more stable than their smaller cousins, this should be reflected in a more stable earnings growth path. Unfortunately that is not always the case. In Europe, earnings growth of large and small caps moved in lock-step from 1996 to 2011 – but they diverged significantly thereafter. While the earnings of small caps continued to recover from the mini-recession in 2012, the earnings of large caps simply collapsed and are now back to the levels of 2001!

Small cap earnings vs large caps - MSCI Europe

Since earnings growth is what drives share price performance, the divergent path is reflected in the superior performance of European small caps over European large capss in the last 10 years. Over that time period, the MSCI Europe Small Cap Index delivered annual returns of 6.15% while the MSCI Europe lagged far behind with only 3.34%. To show the power of compounding, an initial investment of 100,000 Euros in the MSCI Europe Small Cap Index would have turned into 181,000 Euros after 10 years while the equivalent investment in the MSCI Europe would have resulted in a much smaller amount of 139,000 Euros (end of April 2017, in Euros, incl. dividends).

Why did the earnings of large cap indices in Europe suddenly collapse after 2008? Large cap indices have a different sector composition: compared to small caps they have a much higher weighting in sectors that are deemed to be vital to their economy. Sectors such as financials and utilities for example. They exist not only to enrich shareholders but also to fulfill a critical function in society. Governments are much more prone to changing the regulatory regimes for these vital sectors which in turn can severely impact their earnings profile. Following the financial crisis, banks were subjected to much tighter regulation and their earnings potential has never fully recovered. Similar for utilities, which were hit by the shift away from nuclear and coal towards renewable energies.

Conclusions

What you should not do: Don’t go from one extreme to the next. Don‘t go out and buy only small caps stocks. Large caps should still be the cornerstone investment for any long-term financial plan. But small caps also play an important role in portfolio construction.

What you should do: Think first carefully before you invest. Although everyone (including ourselves) praises ETFs, you need more in your portfolio than just some standard indices. If you own only MSCI World or DAX or Euro Stoxx 50 ETFs, you are still not properly diversified. As always, balance is key and the portfolio needs to reflect your personal goals.

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