low return environment favours sector as small firms excel in each quarter bar one since 2000
US smaller companies will continue to outperform over the medium term as markets deliver low to flat returns, according to Boniface Zaino and Jack Fockler of Legg Mason Inc subsidiary, Royce & Associates.
Speaking at a recent London conference, Fockler said small caps outperformed in 80% of the 160 periods of lower and normal return periods, based on rolling 10-year figures since 1930.
Higher return decades, of 17.5% annualised growth or above, favoured large caps, which outperformed in 76% of the 106 higher return periods over the same time frame, according to research carried out by UCLA's Centre for Research in Security Prices (CRSP).
Fockler said: 'We are moving into a low return environment. Since the start of the new millennium smaller companies have outperformed in every quarter except one.'
Fockler and Zaino, managing directors of US fund group, Royce & Associates and joint managers of Royce Opportunities, a sub-fund of Legg Mason's Dublin-based Oeic, said small caps have also outperformed relative to large caps in six years of every decade going back to the 1930s, regardless of which asset class ultimately outperformed over the full decade.
As small caps have outperformed large caps in both 2000 and 2001, Fockler said history supports the theory that they will continue to outperform for the next four years.
Fockler also emphasised the difference in returns from the Russell 2000 Growth and Value Indices. Justifying Royce's deep value stance, the Russell 2000 Value Index has posted cumulative growth of 3255.4% since its inception on 31 December, 1978.
By comparison, the Russell 2000 Growth Index has posted cumulative growth of 997.5% over the same period, equivalent to value outperformance of 6% per year.
Fockler said the Royce Opportunities fund primarily invests in micro caps, stocks with sub-£400m market caps. This gives a universe of some 6,600 stocks, the largest segment of the US market.
He noted: 'It is harder to buy and sell these entities and the trading spreads can be as much as 3%-5%, but the amount of research available is very low and frankly it is where you get excess returns, in our view.'
Zaino said the fund does not target value stocks at the expense of growth stocks, but will not overpay for growth.
The fund currently has 19% in undervalued assets, typically stocks trading below book value, 32% in turnarounds, 29% in undervalued growth stocks and the remaining 20% in interrupted earnings, companies on a low P/E that can attain 20% annual growth rates, spread across a 100 stock-plus diversified portfolio.
Turnarounds form the largest portion of the fund owing to lack of management expertise and a brain drain among small cap chief executives, who are often lured to blue chips with very attractive salary packages.
Zaino explained: 'The objective of what we do is not to hold a portfolio of value stocks but to produce excess returns. Half of it is down to economics and finance, the other half market psychology.'
The Aviva Investors Multi-asset Funds (MAF) target equity risk rather than absolute volatility. Thomas Wells, Multi-asset Fund Manager, explains that while absolute volatility varies significantly over time, the inherent risk of investing in equities remains relatively constant.
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