Small cap stocks: Are they consistently outperforming large caps?

Over the past decade, the frenzy around small-cap companies in India has continuously trended upwards, just like the share prices of small-cap companies themselves. But first things first, how are small caps defined in India? Any company market capitalization rank greater than 250 is categorized as a small-cap company.

In the field of academic research, there is one concept called size risk premium. Research, based on empirical data, shows that small-cap stocks have yielded higher returns than large-cap stocks. The interesting thing to note here is that this has happened across time periods and geographies. Now, what could be a possible logic behind this? Well, this is because of the inherent riskiness of small-cap companies. You see, small-cap stocks are more risky/volatile than large-cap stocks due to a combination of reasons. Hence, the argument is that if an investor puts her money in a smallcap company, she would demand a higher return for the additional risk she is undertaking. 

Also, it is much easier for a smallcap company to grow as compared to a large one. Isn’t taking your revenues from ₹50 crores to ₹100 crores easier than taking it from ₹5,000 crores to ₹10,000 crores? Therefore, the stupendous growth of a smallcap company gets rewarded by the stock markets, culminating in price outperformance for them.

Let us take into consideration historical data from Nifty and check to see whether the smallcap index has managed to outperform its largecap counterpart or not.

1-year rolling returns

Here, we have calculated the 1-year rolling returns of Nifty 100 and Nifty Smallcap 100 from Nov ‘06 to Dec ‘23.

If you carefully observe the chart, you will see that the peaks and troughs for the small-cap index are way steeper than the large-cap index. For example, look at the time period between 2008-09. The small-cap index had fallen much more than the large-cap index during the Global Financial Crisis. However, it recovered faster and much more than the large-cap index. Quite similar is the story during 2014-15 and 2020-21.

Rolling annualized volatility

It is needless to say that the smallcap index is more volatile than the largecap index.

Though the volatility of the small-cap index has come down in recent times as opposed to 2006-07 periods, it is still more volatile than the large-cap index.

Performance during market downtrends

This is where things shall begin to get interesting. Take a look at the performance of the two indices during a few extreme market downtrend events.

There is clear evidence that suggests that small-cap companies witness a much higher degree of price erosion as compared to large-cap companies during market downtrends.

Performance during market uptrends

But things change, as small-cap companies perform much better than large-caps when it comes to market uptrends. Refer to the table attached.

Performance during recent times

Finally, it is essential to understand the role of small-cap companies in your portfolio. While they can be a valuable aspect of your portfolio, they can’t be the only ones in your portfolio. For this, we will take a look at the core-satellite approach methodology to understand.

The first step towards designing a good investment portfolio is to build your core portfolio. Core portfolio (or slow moving portfolio) are investments which are extremely safe and stable and help you achieve basic market returns. A relevant example is an index ETF like a Nifty 50 ETF or a commodity ETF like a Gold ETF that does the job for you.

The other half is the satellite portfolio (or fast-moving portfolio) where investments are slightly riskier and have the ability to generate returns over and above the market returns. This is where a portfolio of small-cap companies could help one generate that additional returns.

To conclude, nothing is foolproof in markets and certainly, there is no free lunch. One should not be under the misconception that just because one is taking higher risks in the form of small-cap exposure, those stocks will deliver superior returns. Choosing quality companies in any market pocket is paramount.

Naveen KR, smallcase manager and senior director at Windmill Capital