Secrets of Success: Think small, and you can't go wrong

Size is among the most important style factors, and can have a huge impact on the way your portfolio performs. Whether you invest directly in shares or buy funds to do the job for you, the market value of the companies you own will be one of the leading determinants of the returns you achieve. If you rank the component stocks in the main market indexes, there is normally a direct correlation between their size (market capitalisation) and performance.

Size is among the most important style factors, and can have a huge impact on the way your portfolio performs. Whether you invest directly in shares or buy funds to do the job for you, the market value of the companies you own will be one of the leading determinants of the returns you achieve. If you rank the component stocks in the main market indexes, there is normally a direct correlation between their size (market capitalisation) and performance.

Sometimes there are periods when large companies outperform smaller ones, and other times when the reverse is true. For a few years in the late 1990s, large-cap was the place to be. The bigger the size of the company, the better you did. Now for a while we have experienced the reverse effect. Small-cap stocks are doing better than large-cap ones.

This is a pattern that tends to be experienced as bear markets come to an end. Whether the phenomenon is symptom or cause is neither here nor there. It is logical that in a severe bear market, like the one we have just experienced, smaller stocks are the ones most likely to be hammered. Their businesses are by definition more vulnerable to economic conditions and, apart from anything else, the market in the shares simply tends to dry up.

When markets recover, and investors suddenly start scrambling to get back into the market, it is small, often not very liquid, stocks that can witness the most dramatic price rises. The strong short-term performance numbers in turn start to hit the radar screens of the professional investment community and the trend starts to reinforce itself.

All these things have been happening over the past year. One consequence is that you can be sure small-company funds will be given the heavy selling treatment in this year's Isa round, though that is rarely a cause for sustained future performance. As the table shows, the smaller-company effect has been a global one. In all the main markets, smaller-cap funds have outperformed broader equity funds over the most commonly used measurement periods. Not only is this true of each market, but, with one exception, a smaller company fund from any one region is likely to have done better than a broad market fund from any other region.

The figures for smaller-company funds in each market are also similar in scale, at least over the past year. This is another telling reminder that we live in a global stock market where the major style trends are highly contagious. Changes in investor sentiment can spread even faster than bird flu and other viruses.

Another interesting feature in the latest statistics is that smaller-company funds have done much better than larger funds without having vastly greater volatility. In logic, and as a matter of empirical experience, you would expect smaller company funds to be riskier and more volatile than funds higher up the market-capitalisation scale. Nor, if you look at the maximum drawdown experienced by the funds in question, is there much difference between small- and large-cap funds.

A word of warning about the figures in the table: what they show are averages for particular fund sectors; each sector will contain a wide range of funds with different characteristics. At the same time, you will be aware of the statistical phenomenon that means one-, three-, five- and 10-year return figures all tend to reflect the impact of most recent performance. A more meaningful way to interpret the figures is to look on a year-by-year basis.

Doing that will not change the power of the recent trend. What investors looking at these figures need to bear in mind is that periods of small company outperformance are usually powerful but relatively short-lived. In fact, looking back across the 20th century, the apparent long-run superiority of small-cap over large-cap was all concentrated into just a handful of individual years. Miss those and you would have missed the whole trend.

I see no reason why the same phenomenon will not repeat itself. If you believe, as seems increasingly plausible, that the recovery from the bear-market lows of last spring is to continue for a while, then it is likely small caps will continue to do relatively well. In the short term, as the old saying goes, the trend is your friend, and it may be worth weighting some of your marginal investment capital in that direction.

On the other hand, you can be certain the trend will not last forever and before long, the merits of large-cap stocks will again be appreciated.

There are signs this may already be happening. The other feature of the past year has been that "junk" (an impolite word for stocks with poor financial characteristics) has done a lot better than "quality". there is some merit in preparing the ground now for a shift towards larger-cap, quality shares when the present period of small-cap dominance shows signs of coming to an end.

The enduring point is that even the best stock-pickers can only do so much when the style trend in the market is working against them.

jd@intelligent-investor.co.uk