Dear investors,
Historically, investments in small caps have proven to be a cost-effective and consistent way to outperform market returns. small caps they are the companies with the lowest market value and which, due to their size, end up being ignored by most investors. This abandonment ends up creating price asymmetries and, consequently, investment opportunities.
In this month's letter, we explore the subject and bring some research based on historical data that shows the advantages of investments in small caps.
Although there is no official definition that establishes whether a company is a small cap, in general, it is considered small cap a company whose market value ranges from US$ 300 million to US$ 2 billion (R$ 1.6 billion to R$ 10 billion at current exchange rates of R$ 5.20). In Brazil, B3 has a stock index small caps (SMLL)[1], which represents a portfolio of 110 companies and, currently (August 2021), the market value of companies in this index varies between R$ 210 million (Recrusul) and R$ 23.8 billion (Banco Pan), with an average of R$ 5, 0 billion – values in line with the international benchmark.
It is often associated small caps The start-ups, companies in early stages or that are not yet profitable. This association is quite wrong. Lots of small caps they are companies with proven business models and a solid and profitable financial history, that is, quality companies that, at the right price, can be excellent investment opportunities.
And such opportunities come up from time to time. Due to their small size, these companies generally have low liquidity and end up being ignored by most investors. Many funds and institutional investors even have legal restrictions that prevent them from investing in small caps.
Furthermore, small caps have additional advantages: (1) given their size, small caps they are easier targets for M&A transactions and (2) companies often still have ample room for growth, which tends to favor the appreciation of their shares.
The big companies of today have already been small caps one day. Investors who limit themselves to investing in large companies sometimes end up investing when most of the share appreciation has already occurred. For example, Magazine Luiza in 2016 was worth R$ 300 million, and today it is worth R$ 126 billion!
There may even be opportunities for growth in large companies, but these situations are rarer. These companies have often already grown enough to reach relevant participation in their markets, and the alternatives for growth become scarcer, or they involve expanding into new markets or geographies, moving them away from the skills and competitive advantages that brought them success first.
These positive factors are reflected in the results of research on the subject. In 1981, Rolf Banz, a student at the University of Chicago, investigated the return of stocks according to their size. he discovered that small caps had higher returns than large caps consistently, even when adjusted for risk.
To analyze this claim, the table below presents stock returns broken down by market size over the period 1926 to 2012.
Table 1 – Returns by deciles according to company size, 1926-2012, USA[2]
| Size decile (smallest to largest) | annual return | Excess return in relation to the CAPM |
| 1 | 17,0% | 9,6% |
| 2 | 12,8% | 3,6% |
| 3 | 11,3% | 1,9% |
| 4 | 11,3% | 1,6% |
| 5 | 11,0% | 0,7% |
| 6 | 11,0% | 0,7% |
| 7 | 11,2% | 0,8% |
| 8 | 10,2% | -0,1% |
| 9 | 11,0% | 0,8% |
| 10 | 9,3% | -0,0% |
| total market | 9,7% | 0,0% |
The annualized return of the smallest shares in the table was 17.0% pa, a level substantially higher than the average market return of 9.7%.
A common criticism of investments in small caps is that they are riskier, and therefore should be avoided or limited in the investor's portfolio. Not what the table above shows. The second column shows the level of return in excess of what would be expected given the volatility level of each group of stocks and it is clear that even adjusting for this factor, investments in small caps show a superior track record of risk-return.
Obviously, the risk should not be overlooked. different from large caps, it is common to find greater difficulties in accessing important information for investment evaluation, but with careful and disciplined analysis, seeking to understand the company's business in depth, we believe that attentive investors are able to identify and manage the risks associated with investments in small caps.
This result is consistent not only in the USA, but in several other countries. Tables 2 and 3 below show, respectively, the results of surveys done for stock returns in the UK between 1956 and 1987 and Japan between 1966 and 1983.
Table 2 – Returns by deciles according to company size, 1956-1987, United Kingdom[3]
| Size decile (smallest to largest) | annual return |
| 1 | 21,6% |
| 2 | 17,7% |
| 3 | 17,0% |
| 4 | 15,6% |
| 5 | 14,7% |
| 6 | 13,7% |
| 7 | 13,1% |
| 8 | 13,2% |
| 9 | 13,3% |
| 10 | 11,4% |
Table 3 – Returns by quintile according to company size, 1966-1983, Japan[4]
| Size quintile (smallest to largest) | annual return |
| 1 | 24,4% |
| 2 | 18,0% |
| 3 | 16,6% |
| 4 | 14,0% |
| 5 | 13,7% |
The above results prove to be true even in Brazil. The chart below shows the returns of the SMLL index compared to the Ibovespa for the period from April 2008 to August 2021. The results show that in the period, the SMLL performed much better than the Ibovespa, with an appreciation of 2.92x (8. 4% aa of annual return), compared to 1.78x of the main index of the Brazilian stock exchange (4.4% of annual return).
Graph 1 – Historical return IBOV vs. SMLL (2008-2021)[5]
At Ártica, unlike most investors, we have a lot of flexibility to invest in companies of any size on the stock exchange, from small caps to the largest Brazilian companies. And our fund is designed exactly for that. The 90-day redemption period, the fact that a relevant part of the fund's capital belongs to our partners, and the long-term vision of our investors allow us to have greater tolerance for investing in small caps.
This wider range of options made it possible for us to find excellent opportunities that were ignored by the market and which were fundamental in contributing to our track record of returns. We hope to keep finding these hidden gems in the bag! In the next letter, we will talk about a specific case of a small cap which is a relevant part of our portfolio today.
[1] The SMLL index is made up of companies that respect minimum liquidity criteria and are classified outside the list of those representing 85% of the market value of all companies listed on the spot market.
[2] The table results reflect the study carried out by Rolf Banz in 1981 updated until 2012 by Jeremy Siegel in his book “Stocks for the long run”
[3] Study conducted by Mario Levis, Professor at the University of Bath, UK and John Moxon
[4] “The Size Effect and Seasonality in Japanese Stock Returns,” Nomura Research Institute, 1984. Conducted by T. Nakamura and N. Terada
[5] Source: B3; Arctic Analysis
