The essential :
- Small and mid-cap companies are listed companies with a market capitalization of between 500 million and 10 billion euros;
- Small and mid caps offer higher yields than big caps at the price of volatility and lower liquidity;
- Small and mid-cap ETFs provide consistent diversification of small and large caps.
Retrospective analysis has highlighted a profitability gap for small and mid-caps (small & mid caps), compared to the broad multinational caps. If this asset class has, on average, better returns, keep in mind that these assets are inherently riskier. Investing directly in a few small businesses is therefore not recommended. It is better to favor a diversified investment.
What is a small or medium capitalization?
The concept of small and medium capitalization is relative. Indeed, small and mid-cap companies are not start-ups but are listed companies. Small caps and mid caps are companies whose market capitalization is below a certain amount.
According to the definition of the financial lexicon Les Echos , small caps are companies whose market capitalization is between 500 million and 2 billion euros. As for mid caps , these are companies whose market capitalization is between 2 and 10 billion euros. Thus, 90% of the listed shares are small and mid caps .
Why invest in small and mid caps?
Ensure better portfolio diversification with small & mid caps
Most French equity funds are geared towards CAC40 shares. Nevertheless, the price of large caps can be very correlated, for two main reasons:
- these companies are sensitive to the same macroeconomic factors, such as the evolution of key interest rates or international trade tensions;
- they are in the same stock market indices, as for example the CAC 40, with regard to large French capitalizations.
For their part, medium-sized capitalisations and especially small caps have markets that are often national or at the scale of a limited economic zone. Their valuation depends more on their intrinsic growth, their ability to innovate and gain market share. They do not all react in the same way to macroeconomic news. By integrating small & mid caps into your portfolio, you increase the diversification of your investments.
See also: ensuring better diversification with foreign equities.
More performance thanks to small and mid-caps
Statistical analysis and academic research show that small companies have, on average, better stock market performance.
Eugene Fama , winner of the 2013 Nobel Prize in Economics for his work on the efficiency of the financial markets, has thus completed the methods for valuing financial assets (CAPM) with a so-called ” three-factor ” model. In this analysis, it highlights the existence of a “risk premium” for small and mid-caps. The risk premium is a surplus performance that rewards the investor for holding a riskier asset.
If Eugene Fama had initially validated this result in the US market, the empirical analysis has been extended to all geographic areas since then.
The outperformance of small and mid-caps can also be seen by comparing the evolution of the small caps versus the large caps . For example, since 1990, the average yield of the S & P 500 (the 500 largest US market capitalisations) is 6.6%, where, by adding the following 1,500 companies in order of size (Russel 2000 index), the annual rate reaches 7.14%.
Risks related to small caps and mid caps
The higher volatility of mid and small caps
Individually, a small company has a greater risk of default than a larger company. This is due to many factors: a weaker balance sheet, a less diversified activity, a lower financing capacity, a less well-known brand, etc.
In stock prices, this translates into greater volatility for small caps. The volatility of an asset measures the average amplitude of its fluctuations, both up and down. The more volatile an asset is, the greater the risk of loss in the short term.
Take the example of the S & P 500 and Russel 2000: the historical volatility of the first index is 16%, that of the second is 20%.
Small-cap liquidity risk
Small and mid-cap stocks are listed on the stock exchange and normally offer instant liquidity. This is indeed the case for most of these actions. Nevertheless, some listed companies may have a very low capitalization of just a few million euros. The price of their shares rarely exceeding one euro, are called “penny stocks”. These, although publicly traded, may have a very low trading volume and may therefore present a liquidity risk, especially in times of stress. We therefore recommend to avoid them.
How to invest in small and mid caps?
As we have seen, small and mid cap stocks perform better than large ones, but they have greater volatility. In order to contain this volatility, it is important to diversify your investment. We therefore advise against investing in individual securities or individual actions, but rather to invest via ETFs .
ETFs (or trackers) are index funds that replicate the performance of a stock market index. The benefit of index funds is twofold:
- stock market indices are broad, these funds will have several hundred underlying, ensuring good diversification;
- Since replication is automatic, ETF management costs are very low compared to traditional funds: 0.25% per year on average for an equity ETF versus 1.7% for conventional UCITS.
For example, the MSCI Europe Small-Cap iShares ETF allows investors to invest in European small caps, and the Amundi ETF Russell 2000 on US small caps. These funds also provide good sector diversification, as an illustration, the iShares ETF MSCI Europe Small-Cap has the following breakdown:
- industrial sector (21.42%);
- financial services (14.81%);
- technology companies (10.32%);
- real estate (10.15%).
And that with companies spread throughout Europe.
By multiplying the different ETFs in your portfolio, diversification is maximized and the volatility effects of small and medium-sized ones are partially offset.
You can invest in these ETFs with all your tax envelopes : life insurance, securities account, PEA or retirement savings, provided your bank or insurer makes ETFs available.
Read also: life insurance and ETF , the winning combination.
What Nalo does for you
Nalo is an investment company dedicated to individuals. With Nalo, you can subscribe online to a life insurance policy that we manage financially. We put in place a tailor-made management strategy, adapted to your financial projects and your heritage environment.
In order to reduce management fees, Nalo only uses ETFs, and to maintain good diversification as well as to maximize the earning potential, we integrate ETFs exposed to small and mid caps.