Growth bested value among U.K. small-cap stocks in 2010, following a decade-long trend, according to a Royal Bank of Scotland report released Jan. 13.
U.K. small-cap value stocks returned an average of 18% for the year ended Dec. 31, while small-cap growth stocks posted an average 28%, according to the RBS Hoare Govett Smaller Companies index, which gauges the smallest 10% of companies by cap size traded on the London Stock Exchange.
The outperformance of growth among small-cap stocks is unusual despite the recent trend, one of the report's authors said. Over the 56 years of available data, value has outpaced growth.
Meanwhile, a similar reversal exists between the performance of larger small-caps and smaller ones. While smaller companies within the HGSC index have outperformed over the long haul, larger ones have done better in each of the past 10 years.
“Over the long run you'd say (microcap) value has done well,” said Paul Marsh, emeritus professor of finance at London Business School and one of the authors of the annual report, RBS HGSC Index 2011. “But there are times when styles are in favor and out of favor.”
Over the entire 56-year history of the index, microcap value stocks posted an annualized average 20.7%; midcap value, 18.6%; midcap growth, 14.5%; and microcap growth, 13.2%, according to the report. The authors define microcap as the smallest 70% of capitalizations within the index, while midcaps are the largest 30%. Value stocks are defined as the top 40% of the index by book-to-market value ratio, with growth stocks being the bottom 40% based on the same ratio. The middle 20% of the index is ignored.
The latest contrary trend among the size and value risk factors is the longest on record in the index's 56-year history, Mr. Marsh said.
A similar trend has been seen in the U.S. market, however it has been less pronounced, he said.
“No style remains in favor indefinitely,” however “predicting (a reversion of the trend) can be tricky,” Mr. Marsh said, adding that to do sector rotation right is “a bit like market timing. It's great in theory to talk about the benefits of market timing, but it's hard to get it right consistently.”
Small-cap managers would do well to “take it on the chin” when their style focus is out of favor rather than venture into sector rotation, Mr. Marsh warned.
Explaining why value and microcap stocks have failed to outperform in the past decade isn't easy, either. “The puzzle really has been the (outperformance) of the midcaps,” Mr. Marsh said. That's probably due to a number of factors. First, midcaps include certain sectors, such as the natural resource (oil and mining) sector, that have been in favor. Also, Mr. Marsh said it may be a matter of attention: global investors are happy to invest in midcap markets, which are more liquid. Microcaps require more monitoring.
Growth stocks often perform well in periods of economic recovery because investors see them a way to capture economic growth. “A particular theme this time round has been seeking stocks with exposure to emerging markets — (which are also) seen as part of the growth story,” Mr. Marsh said in a follow-up e-mail. He added that value stocks typically are out of favor during recovery: “With investors remaining somewhat nervous of stocks in general after two massive bear markets within a decade, they may have wished to avoid value stocks.”
Overall, U.K. smidcap stocks returned 26.4% in 2010, outperforming the FTSE All-Share index by 11.9 percentage points, according to co-authors Mr. Marsh and Elroy Dimson, London Business School emeritus professor of finance.
Over the history of the RBS HGSC index, smaller companies have outperformed larger ones in the FTSE All-Share index by an annualized average 3.4%. Also, small-cap stock performance outpaced that of large caps in 21 of the 26 countries studied, including in the U.S.
In some markets, underperforming large companies were the culprit. In Ireland, for example, large-cap stocks are dominated by bank stocks, which were pummeled in the lead-up to an €85 billion ($113.8 billion) bailout from the European Union and International Monetary Fund (Pensions & Investments, Nov. 29, 2010).
Mr. Marsh pointed out that an investment of £1,000 ($1,585) in the RBS HGSC index in 1955, with dividends reinvested, would have been worth £3.3 million as of Dec. 31, vs. £620,000 for the same £1,000 invested in the FTSE All-Share index.
Mr. Marsh believes there are theoretical reasons for a small-cap premium to exist — they're slightly riskier or more volatile than large caps, and small-cap markets are less liquid than larger ones. In fact, the relative riskiness of RBS HGSC stocks has “crept upwards” in recent years as the FTSE All-Share index has become more diversified and low-volatility stocks, such as those of utility companies once owned by the government, have been added. Also, the performance of individual small-cap stocks have become more correlated to the broader market.
RBS expects smidcap stocks to continue to outperform in 2011, Stephen Ford, head of U.K. midmarkets at RBS, said in a news release accompanying the annual report.