Han Dieperink: The negative small cap premium

December 12, 2023

Equity Small caps

^{This column was originally written in Dutch. This is an English translation.}

By Han Dieperink, written in a personal capacity

Small caps are mentioned as one of the big contenders for next year. This expectation is mainly based on their historical underperformance compared to large caps and the resulting low valuation.

However, it appears that previously successful small cap companies are increasingly opting for private equity financing and avoiding the stock market. These companies only go public if there is a need to create more liquidity for existing shareholders. Usually there is no longer a small cap, regardless of whether it is the right time to enter.

The small cap premium

In 1981, Rolf Banz wrote an article about the relationship between market capitalization and stock returns. Even adjusted for risk, he concluded that small companies performed better than large companies. It was not a linear relationship and it was particularly true for the smallest capitalized companies (small caps).

The irony is that that small cap premium has virtually disappeared since 1981. Now here too, correlation (small caps and performance) does not necessarily mean causality. The outperformance of small caps up to 1981 is probably simply a consequence of an illiquidity premium combined with an information deficit. Much has improved since then, both in terms of liquidity and information (internet), although the introduction of various rules (including Mifid) has caused the liquidity of small caps to deteriorate again in recent years.

No more going to the fair

This century, a factor has been added that may contribute to small caps even performing worse than large caps in the future.

Smaller companies in themselves have many advantages. They are flexible, which means they can adapt much better to rapidly changing circumstances. In addition, the arrival of the cloud has ensured that small companies can compete well with large companies. Where in the past a large IT system had to be purchased, the same can now be accessed better, faster and cheaper via the cloud as a service for the smallest companies. While the largest companies are stuck with old and slow software systems that are difficult to adapt.

Nowadays, small companies that opt for a stock exchange listing are mainly confronted with the costs of such a listing, while the benefits are increasingly fewer. These companies prefer to opt for financing via private equity. This means that the fastest growing small caps will disappear from the stock market. And with that also the small cap premium.

Globalization and technology

Furthermore, the small cap premium has also disappeared because large companies have benefited much more from globalization. Perhaps even more important is the influence of technology. Small caps today benefit from software as a service, but existing large companies have benefited much more from the productivity improvements in existing processes resulting from technology. That remains true to this day.

When it comes to artificial intelligence, more data is always better than less data. The cloud cannot be big enough for this and this is particularly beneficial for the large cloud companies. Moreover, many of these large companies behave like private equity. Many such listed large technology companies are buying small technology companies at an early stage.

Stock exchange listing is a tax without added value

The costs of a stock exchange listing are now much greater than in the past. It easily costs 10% of the market capitalization to go public. But there are also numerous obligations in the field of transparency and reporting. For example, European listed companies must report on numerous sustainable topics next year. European small caps have a year's grace, mainly due to the extensive administrative burden.

The administrative burdens have increased sharply since the turn of the millennium, also due to scandals involving Enron and Worldcom. For example, listed companies had to comply with Sarbanes-Oxley (SOx) (here in the country, including Tabaksblat and the COSO guidelines) and that quickly cost tens of millions per year per company, with the threat that if the board was not 'in control' these people could go to prison for that. More recently, Boskalis threatened to leave the Netherlands simply because it would be held responsible for the behavior of suppliers. For many companies, all these regulations serve as an additional tax with no added value in return.

The benefits of private equity

The simplest way to avoid these regulations is to no longer be listed on the stock exchange. There used to be advantages to a stock exchange listing, including in terms of reputation and access to capital markets, but now the pockets of private equity are just as deep as the pockets of capital on the stock exchange.

For financing with debt capital, the flexibility of private debt is even a relief compared to the Basel III-based credit conditions of the banks, where if only one check box is missing, large listed companies also receive no response. Companies that would come to the stock exchange for the first time would prefer to opt for private equity. Furthermore, private equity is not interested in every small company, but only in profitable, fast-growing companies. These darlings are exactly the companies responsible for the small-cap premium.

Lower quality small caps remain

Because fast-growing IT companies and other fast-growing and highly profitable companies no longer come to the stock exchange, the small cap category also takes on a somewhat one-sided character. An increasing share of small caps consists of companies that do not (or no longer) make a profit. These may have been much larger companies in the past, but they have lost out to the competition. Thanks to low interest rates, they were able to finance themselves cheaply for a long time, but now that that time is over, they have often become zombie companies.

A growing part of the companies that are not yet making a profit are biotech companies. Like zombie companies, these are dependent on the capital markets for future financing. It is precisely these companies that are being hit hard by the tightening monetary policy. The bad thing is that these companies will only experience the full impact of the recent interest rate increases next year. That does not help the average small cap.

Only if interest rates fall quickly can these companies also outperform. But that interest rate will only fall sharply if there is a severe recession. And unfortunately, small caps appear to be above average sensitive to such a recession.