There is a common perception that stocks with a smaller market capitalization tend to generate higher returns than stocks with a larger capitalization.
Because small-cap stocks are lighter in size and lower in price, they rise faster than the larger stocks with greater percentage gains over a period of time.
For example, when the stock market rallied from a low of 7,514 in October to 8,216 in one month, about 80 percent of the top 10 gainers are small stocks with market cap of less than P10 billion.
The small-cap stocks, led by the likes of Liberty Flour, SunTrust and Now Corp, made an average gain of 37 percent against the blue chip stocks’ advance of 9 percent.
However, small-cap stocks tend to carry more risks. Smaller stocks have less liquidity, which is the primary reason why people buy and sell stocks in the market.
Lack of liquidity makes it difficult to trade small cap stocks quickly at market price. It also prevents large institutional investors from buying into these stocks, resulting in less research coverage and market support.
Given the high volatility of small-cap stocks, we can say that the higher returns accruing to small-cap stocks are more attributable to higher risks rather than to superior fundamentals.
Let’s say there is a small-cap stock that we find as very risky because it has poor profitability track record and no growth prospects.
But we think that its stock price has great upside potential because it is well promoted by speculators.
In standard finance, we define that the required rate of return we can expect from investing in stocks is equal to the risk-free rate plus the risk premium.
To estimate the return of investing in this small-cap stock, we can assume that the risk-free rate is the prevailing 10-year Philippine bond yield at 4.69 percent.
Then, we add a risk premium of 10 percent, which is double the average risk accorded to profitable stocks.
Since the stock has poor trading liquidity, we can also put an additional risk premium of 5 percent.
In total, the minimum return we can expect from investing in the stock is 19.69 percent in order to compensate for our risk.
If the small-cap stock generated a return of 27 percent and your minimum return is 19.69 percent, this means that your “risk-adjusted return” will only be 7.3 percent.
Now, if you bought a blue chip stock that generated a lower return of 17 percent but has lower risk at a return of 9.69, which is the sum of risk free rate at 4.69 percent and 5 percent premium, you will still get the same net return of 7.3 percent.
In other words, while small-cap stocks may outperform the larger stocks, it takes more risks to invest in smaller stocks to get possibly the same net return that you would have earned from larger stocks.
And because small-cap stocks are riskier, they are also vulnerable to larger declines during a market downtrend.
For example, last November, following the recent market correction, when the PSE index fell from a high of 8,216, seven out of the top 10 losers are all small-cap stocks.
These stocks, which were led by Cirtek, MRC and Harbor Star, yielded an average loss of 27 percent, larger than the average loss of large-cap stocks at only 4 percent.
Interestingly, if we look at the annual returns of listed stocks at the PSE, the larger stocks with market cap of P100 hillion and above have outperformed the smaller cap stocks of P1- billion below in four of the last five years since 2015.
The mid-sized stocks, on the other hand, which have market cap of between P10 billion and P100 billion, also outperformed the smaller stocks in three of the last five years.
While small-cap stocks may be superior to larger stocks occasionally, especially in period of rising prices, they do not provide above average returns on a consistent basis due to higher volatility and risks. INQHenry Ong is a registered financial planner of RFP Philippines. Stock data and tools provided by First Metro Securities.
To learn more about investment planning, attend 81st batch of RFP Program this January 2020. To register, e-mail info@rfp.ph or text at 0917-9689774