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Professors Eugene Fama and Kennet French recently made headlines with the introduction of their new model, the five-factor asset-pricing model.
Now, the Fama and French model may sound like a fancy margarine brand to you, but these highly skilled specialists are the people who helped to improve the one-factor model that made its first appearance in 1964.
Without delving too deep into this model’s history, it was developed as a valuation tool to determine the beta valuation of assets – a subject that has been the focus in many of my previous articles. For many years, it was used as one of the very few and most advanced tools available to investment specialists.
By 1992 it became clear that the one-factor model fell short of its mark, and Fama and French jumped in to save it by adding two additional factors, making the three-factor model one of the most famous and successful theses in financial and economic history.
I have discussed one of these factors on numerous occasions, namely that over time, value shares yield better returns than growth shares. This week, however, I would like to tackle the second factor: that small company shares deliver better returns than larger company shares over the long term
But why do they deliver higher returns? The main reason can probably be attributed to the fact that smaller companies pose higher risks, and therefore require extra compensation to cover those risks. Whether you agree with this statement or not, I would like to give investors who are interested in small market capitalisation shares some food for thought this week.
Before I continue, however, let’s just quickly put this into South African context. Small market cap shares are shares that fall outside of the Top40 (largest shares) and the following 60 medium-cap shares. As I have done before, I decided to take a look at what the experts are doing in the SA Equity Small and Mid Cap Unit Trust sector.
I mentioned last week that only 17% of all SA General Equity Unit Trust Funds managed to outperform the FTSE/JSE All Share Index (Alsi) over the last 12 months, which isn’t only alarming when you consider the level of expertise involved, but more importantly, that investors paid 1.7% (the total expense ratio) on average for this underperformance.
There are, however, far fewer funds in the SA Equity Small and Mid Cap Unit Trust sector and one should keep in mind that although this sector’s benchmark is not the Alsi, five out of a total of nine funds (56%) managed to outperform the Alsi over the last 12 months (ending September 2016).
When viewing this over the long term, we finally manage to fit this puzzle piece into Fama and French’s factor model. If you had invested R10?000 in both SA General Equity Unit Trusts (which mainly uses the Alsi as benchmark) and SA Equity Small and Mid Cap Unit Trusts 20 years ago, your investment in SA Equity Small and Mid Cap Unit Trusts would have been worth roughly R50?000 more than your other investment today.
Of course the risks were much higher, but if you had allocated only a small percentage of your portfolio towards smaller companies, you could have made a considerable difference to your final investment total.
Out of the nine available funds, there are five small-cap shares that appear most often, and they are:
- Adapt IT
- Ascendis Health
- Hudaco
- Peregrine
- Spur Group
I’m definitely not recommending that you rush off to buy these five shares on impulse. Do your homework and familiarise yourself with the possible risks involved. I do feel, however, that smaller companies deserve a spot in any well- diversified investment portfolio.
Schalk Louw is a portfolio manager at PSG Wealth.
This article originally appeared in the 20 October edition of finweek. Buy and download the magazine here.
