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The case for small caps.

April 2022

Key points

Academia has taught us that size matters – provided you can effectively control for quality. Fortunately, as Steve Vaughan explains, that is the fundamental role of active stock pickers.

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Founded in 1854 by the Swiss Government as a centre of excellence for science and engineering, the Eidgenössische Technische Hochschule (ETH) Zürich wields influence over all our lives. It also has a surprisingly deep impact on our International Smaller Companies portfolio. Sensirion, a portfolio company supplying connected environmental sensors, was spun-out from ETH and remains nestled on the eastern shore of the Zurichsee. Across the lake sits its portfolio neighbour and fellow ETH graduate, u-blox, which designs tiny GPS receivers for industrial applications: an example of investment ideas begetting ideas when you pull the thread. We see these companies’ abilities to recruit highly talented ETH alumni as part of their respective competitve advantages and the sort of intangible asset that spreadsheet capitalism often undervalues. Perhaps one of those alumni will add to ETH‘s tally of 22 Nobel Laureates, which includes Albert Einstein, who graduated from and then later taught at the institute. But there is another ETH engineering graduate who may have passed you by, but whose work is pivotal to making the case for small caps, Rolf Banz.

Eidgenössische Technische Hochschule (ETH) Zürich.

After leaving ETH, Banz went to the University of Chicago where his doctoral dissertation, The Relationship Between Return and Market Value of Common Stocks was first to document the ‘size-effect’. In it, Banz cautiously concluded that “on average, small NYSE firms have had a significantly larger risk-adjusted returns than the large NYSE firms over a forty-year period”. This finding had a huge impact on capital markets and approaches to asset allocation, kickstarting an industry of small-cap investment funds, including one he started himself. 

Banz’ finding of higher returns for smaller companies now seems like received wisdom. And common sense. It chimes with what we have witnessed of the verve and potential routinely displayed by many of the small companies we encounter, and the marked discrepancies we spot in the valuations placed on that promise from time to time. It is also reflected in the data. A dollar invested in US large cap in 1926 was worth a nominal $5,767 in 2017. The same dollar in small cap grew to $38,842, a staggering difference. Outside the US, our own MSCI ACWI-ex US Small Cap index has outperformed its all-cap peer by a similar 2 per cent per annum over the past 20 years.

You can therefore imagine our discomfort when subsequent research credibly challenged Banz’ small-cap effect. Objections included that it only exists in January, or for micro-caps, or only for certain periods of history. It took a fascinating paper by Cliff Asness and team to explain why the objectors were wrong, and size did matter. He was able to re-establish that smaller companies could outperform, but with a significant caveat – that active selection matters.

Asness’ approach was the first to take into account the strong correlation between firm size and quality. Good quality companies outperform their opposite, termed junk in the study. Quality includes well-managed, growing businesses with competitive advantages. Junk includes those in their dying throes or those with undifferentiated commodity offerings on which no excess return will ever be earned.

The paper’s key insight is that the lack of selection pressure means that the smaller companies universe has a higher proportion of junk stocks than a large-cap index. A large company must have achieved a minimum level of competence to grow to size but anyone can start a small company. And, in the US, for those that avoid Chapter 11 bankruptcy, the small company universe is where big businesses go to die. The studies which had compared the performance of a smaller companies universe with a larger companies universe without factoring this in were blurring the positive size effect which Banz initially discovered, with a negative quality effect. That had diluted the outperformance, leaving it open to challenge. That small caps have generated such optimism despite this handicap hints at the true potential which active management can unleash.

By taking this into account, Asness’ team were able to compare like-for-like and thereby show that small size can matter. Small-quality companies outperform large-quality companies, small-junk companies outperform large-junk companies but small-junk companies do not necessarily outperform large-quality companies.

As active stock pickers, our investment research has always involved controlling for quality when searching within small caps. Our investment universe is vast (perhaps 30,000 listed companies meet our market cap and liquidity criteria), but this opportunity set is exciting because there are real gems to be found within it. Our belief has always been that high-quality smaller companies, run by managers whose interests are aligned with our clients, are likely to generate not only excellent long-term investment returns, but returns that are greater than those that can be found among larger companies.

Size matters, and in a much bigger way than previously thought...Controlling for junk a much stronger and stable size premium emerges that is robust

Why might smaller companies outperform?

Given the strong empirical evidence, the next puzzle is why quality companies may outperform their larger brethren. In theory, an efficient market should have competed away the higher returns of such smaller companies over the 40 years since Banz’ work. Some will plead that the extra return is simply compensation for risk. We find that difficult to believe given that quality is perhaps the best proxy for risk in any fundamental sense and quality companies perform more strongly. We accept that some of it is likely compensation for lower levels of liquidity, and our response is to capture that benefit for our clients with a long-term time horizon and low turnover. Yet we are confident there is more to it than that, and that the most relevant factor is their greater potential to grow the value they create for shareholders. Share prices follow fundamentals over the long term.

The lower starting point gives small-company fundamentals more room to improve. And to do so at a pace, which is misunderstood and mis-priced. This is backed up by Michael Mauboussin’s work on fundamental growth rates for companies of differing sizes, which demonstrated that companies with sales of $700m–$1.25bn grew those sales at an average rate of eight per cent over five years, double the four per cent growth rate of companies with $7bn–$12bn of sales. The proportion of the smaller cohort who managed to at least double their sales over five years was also twice that of the larger one. Smaller companies are a richer hunting ground for opportunity and scalability and, therefore, for longer-term investment returns.

© Stephen R. Johnson/Alamy Stock Photo.

Skin in the game

However, the true smaller company superpower may lie in one particular spoke of our investment research framework. Alignment is multi-faceted, but the core idea is partnering with management teams who act like owners rather than mercenaries. And because we like to keep things simple, finding managers who are owners is a great way of doing so. Behind this lies the idea of agency costs that arise when ownership and control are separated. When a manager owns the whole business, they bear all the costs of that corner office and presumably derives more satisfaction from it than the additional profit they are forgoing. As their ownership stake decreases, the costs to them personally of such tokens fall and consumption of them increases. The same rationale applies inversely; as the manager’s share of any potential gains reduces, so their motivation to endure the stress of growth declines. The interests of the manager and the shareholders diverge when the manager lacks ‘skin in the game’.

The agency problem is well recognised. Modern corporate governance aims to overcome it by binding management and owner together mechanistically through rules and regulations. Remuneration consultants turn to elaborate plans involving options and restricted stock. The asymmetric nature of such awards – managers win if they hit targets but do not lose if they do not – still fails to produce true alignment between managers and owners, as a litany of corporate scandals bears witness.

As ownership increases agency costs fall. And like any cost, a sustained fall increases profitability and the value of firm. This effect is born out in our experience and numerous academic studies, dating as far back as the late 1980s. This relationship between inside ownership and outcomes is not only positive but potentially meaningful. For example, Christoph Kaserer and Benjamin Moldenhauer correlated a 1 per cent increase in inside ownership with ~10 basis points per annum increase in share price performance. Our own research suggested that businesses where a family or founder owned more than 10 per cent outperformed by 3.4 per cent per annum over a fifteen-year period.

The great news for smaller company investors is that academics also confirm that size and inside ownership are inversely related. So smaller companies have higher average levels of inside ownership, linked to factors like their relative age and fewer of the dilutive capital raises required to grow. 86 per cent of the International Smaller Companies portfolio, by weight, has someone we consider a meaningful inside owner: companies such as Hotel Chocolat where the two co-founders own over half of the business or where a young, ambitious lawyer with a 22 per cent stake is taking on the establishment. If businesses with inside ownership outperform the alternative, and smaller companies are more likely to have inside owners, then our argument that alignment might be a key part of the small-cap effect feels plausible.

Much of this, and particularly the agency problem, is widely known. Looking at the shareholder register should not yield insight, yet the superior returns apparently on offer for taking it into account suggest otherwise. A bit like the small-cap effect itself, this lasting outperformance seems to puzzle all who encounter it. The evidence suggests that investors do try to adjust by valuing businesses with inside owners more highly. But they consistently undershoot and underestimate the benefits.

Speedboats and oil tankers

Getting alignment right is a powerful driver of long-term investment returns, perhaps even the most important. It links to the small-cap effect through agency. Agency is not just about costs; its more fundamental definition turns on capacity, capability and self-determination. Great inside owners, particularly founders, feel that agency more acutely within small businesses. The nimbleness of relative size means they can shape their own destiny and fulfil their potential. Our investment philosophy and process hinges on searching for and investing in that potential because we believe that both theory and reality tell us it is often overlooked by financial markets. Rolf Banz’ work took place at Chicago, in the cradle of the Efficient Markets Hypothesis. He stood in front of a doctoral examination committee of its biggest proponents and argued they were wrong. He had faith in a contrarian insight into the way the world works, risked starting a company on it and ended up redefining an industry. We aim to continue the strong tradition of small-cap investing he pioneered. We see a clear path from there to superior investment returns for clients.

Risk factors

The views expressed in this communication are those of Steve Vaughan and should not be considered as advice or a recommendation to buy, sell or hold a particular investment. They reflect personal opinion and should not be taken as statements of fact nor should any reliance be placed on them when making investment decisions. 

This communication was produced and approved in January 2022 and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.

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Annual past performance to 31 December each year (net %)







International Smaller Companies Strategy Composite






MSCI AC World ex US Small Cap 






MSCI World All Cap






Annualised returns to 31 December 2021 (%)


1 Year

Since inception

International Smaller Companies Strategy Composite



MSCI AC World ex US Small Cap 



MSCI World All Cap



Source: Baillie Gifford & Co, US Dollars.

Changes in the investment strategies, contributions or withrawals may materially alter the performance and results of the portfolio.

Please note as the strategy’s launch date was 28 February, 2019, full historic performance is not avalailable.

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The images used in this communication are for illustrative purposes only.

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