The case for small caps

Consultancy firm Aon is arguing the case that global small cap equities should be playing a bigger part in portfolios at the moment.

Small cap stocks represent about 20 to 25% of the global equity universe. (The definition of a small cap stock differs depending on the region, but these companies are typically less than US$1 billion in market capitalisation).

Despite being such a substantial part of the global equity investment universe, the sector is probably under-represented in portfolios.

One of the benefits of the small cap stock sector is that it is generally less efficient, therefore provides greater opportunities to add value.

Smaller companies are not as heavily researched as larger companies. For example, the average company of US$50 billion or more was researched by 24 analysts in 1999. The average sub-US$500m company was researched by just three analysts.

Aon says the situation is similar in Europe where more than 90% of the analysts' focus is on the top 70% of the market.

"This lack of focus on the smaller end of the market provides significant opportunities for active managers to add value," Aon says.

In the three years to 30 September 2001 the median global large cap manager achieved 8.1% pa, outperforming the global large cap index of 7.9% by 0.2% pa. In the same three year period the median global small cap manager earned 16.3% pa, outperforming the global small cap index of 11.4% by 4.9% pa.

Aon also argues that adding small cap stocks increases diversification and therefore has a beneficial impact on the risk and return characteristics of the fund.

Perhaps one of the strongest reasons for having small caps in a portfolio is that this sector has historically outperformed as economies move out of recession.

"Past experience indicates that small cap stocks begin to outperform before the recovery takes place, as investment markets anticipate the improved economic conditions," Aon says.

"With most commentators suggesting that Europe and the US should recover mid next year, this would appear to be the perfect time to be investing in smaller companies."

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