When I started out in finance some decades ago, one of my first roles was working in the sales and business development area for a major fund manager who specialise in Australian Equities. One of the presentations that we would regularly roll out to financial planners and their clients was focused on the benefits of a diversified share investment across not just a small portfolio of Blue Chip Large Cap (capitalisation) shares, but a much bigger portfolio of medium and small caps as could be achieved funnily enough through the use of our Managed Fund.
The slides in the presentation would depict the change on the top ten biggest listed companies in the Australian Share Market across various decades going back twenty or thirty years and showing how what was considered Blue Chip, big and safe, wasn’t necessarily still in the top ten or possibly even listed in the Share Market many decades later. By diversifying your shares across a much larger number of sometimes smaller companies would improve the resilience of your portfolio across the years. You can see the kinds of changes I mean here, The ASX top 10 ? then and now
What I took away from this presentation was a little bit more mathematically simplistic and that is if the top ten companies of today are not the same top ten companies of the past then one of two things has to have happened; either the value of those top ten companies has to have fallen more than the value of those companies smaller than them, or some of the smaller companies need to have grown at a faster rate and overtaken the big companies to now replace them in the top ten. This is true for larger segments, say the top fifty stocks versus the next one hundred and fifty.
I’ve held this belief that small caps and medium caps size shares, or companies, outperform their larger brethren over the long time for pretty much my entire working career. Although there has been much research and debate about factors that add value to portfolios over lasting time periods, such as those discovered by Fama and French and some of their earliest research, right out to a very recent publication from VanEck around Equal Weighted Portfolios, one of the truly consistent long-term factors is this ability of smaller companies to outperform larger companies over the long term. Even if this trend may work in reverse over shorter time periods, such as recently after the global financial crisis in 2007 where there was a sustained outperformance by large caps over the rest of the market as many investors sought safety and quality in big names and big brands.
It has been long thought that the distribution of performance across the majority of the market was normally distributed, that is, around the average return of the share market as a whole, the majority of stocks would cluster and then with a small number of outliers both positive and negative in the tails on the distribution. However, recent research has confirmed what instinctively we know from the outperformance of small over large is that these distributions of returns of individual companies and their share prices is actually skewed to the positive.
This also makes some instinctive sense in that if you have a losing investment on a share, generally speaking, you can only lose a hundred percent (100%) of the value of that investment. Once the share price goes to zero, you’re done. However, there is no cap to the upside, a share price can double and double again and double again in the right circumstances. Therefore, in a distribution curve the tail to the right for positive returns can be quite long and disproportionate to the losses on the left.
By choosing to pay less attention to the large cap nature of most share indices, like the S&P/ASX 200 or the All Ordinaries Index, which are market cap weighted such that the biggest and most valuable companies have the largest proportionate weighting in the index, to focusing on some other form of weighting; whether it would be equal weight or a cap on weighting for the largest investments, will help potentially capture some of the natural bias in share markets to the outperformance of the smaller, under-dog companies.
So, when you’re constructing your share portfolio one of the many inputs you might want to consider will not just be the appropriateness of “Blue Chips” in your portfolio, but how much faith you put in size over statistics.