Impact of Large and Small Cap Stocks on Fund Performance
Understanding the difference between large cap stocks and small cap stocks will enable investors to comprehend a fund’s performance better and how their prices behave in different market cycles.
A fund’s performance is dependent on its portfolio’s exposure to stocks of different sizes during various stages of a stock market cycle.
Large cap stocks vs. Small cap stocks
Large cap stocks are normally defined as companies with relatively high market capitalisation. In this context, market capitalisation refers to the total market value of a company and is obtained by multiplying the company’s stock price by the total number of shares in issue. Large cap stocks tend to be industry leaders, have established track records and generally enjoy stable earnings growth. Due to their size, they are better equipped to ride out challenging economic times compared to smaller cap stocks. As a result of these features, the share prices of large cap stocks are relatively more resilient than smaller cap stocks.
In contrast, small cap stocks tend to be new players or operate in new growth industries. Due to their smaller profit base, small cap companies can generate higher earnings growth rates compared to large cap companies. However, their earnings tend to be less predictable and are more vulnerable to changes in economic conditions. For this reason, small cap stock prices are more volatile. Thus, they are considered to be riskier investments when compared to large cap stocks.
In general, large cap stocks tend to outperform during the early stages of a market upcycle but, small-cap stocks will typically outperform large caps at the later stages of a market cycle. This shift in performance is attributed to the rotational buying interest of market participants comprising institutional as well as retail investors. As such, unit trust funds that focus on stocks of different sizes will register a range of performances depending on their portfolios’ mix of large-cap stocks versus small-cap stocks.
Performance of FBM KLCI and FBM Small Cap Index
To illustrate the volatility of small cap stocks relative to large cap stocks, Chart 1 shows the performance of the FBM KLCI and FBM Small Cap Index since 1 January 2000 to 27 February 2015. As the local market sustained losses in tandem with global markets following the dot com bubble in 2000, the subsequent 7-year period (starting from April 2001) saw the FBM KLCI rebound by 174.0% up to January 2008 before the onset of the Global Financial Crisis (GFC). Meanwhile, the FBM Small Cap Index registered a comparable gain of 158.9% over the same period.
Following the post-GFC consolidation of the domestic market, the FBM Small Cap Index rallied by 221.0% from March 2009 to an all-time high in August 2014, outperforming the FBM KLCI’s gain of 122.6% over the same period. However, as Bursa Malaysia retraced from late August 2014 to 27 February 2015, the FBM Small Cap Index fell by 14.1% as compared to the smaller decline of 2.7% registered by the FBM KLCI.
Chart 1: FTSE Bursa Malaysia KLCI and FTSE Bursa Malaysia Small Cap Index (January 2000 to 27 February 2015)
Public Mutual’s Investment Strategy
Public Mutual adopts an investment philosophy of investing primarily in stocks with strong fundamentals and resilient earnings. This investment approach enables our funds to ride through challenging periods of market volatility to deliver commendable performance over the long-term.
Since the market correction in late 2014, the resilient performance of Public Mutual’s funds reflects our fundamental approach to stock selection, which is focused on achieving consistent long-term returns. Our investment universe includes both large and small cap stocks as selected small cap companies have the potential to grow over the years into companies with larger market capitalisation. This approach to the funds’ investment process will help to provide consistent returns for unit holders over the long-term.
Rotational buying in different stages of market upturn
Following a market downturn, the subsequent rebound in the market is usually driven by buying support of institutional investors in large cap stocks. Sustained buying interest in large cap stocks over the course of a market’s extended gain may result in the valuations of these stocks reaching levels that are no longer deemed attractive. This may prompt market participants to subsequently search for value in small cap stocks. As such, rotational interest into small cap stocks generally occurs towards the mid or late part of a broad market upcycle. At this stage, retail investors become increasingly excited and active in the market.
During periods when small cap stocks outperform large cap stocks by a significant margin, unit trust funds which focus their investments in small cap stocks would inevitably outrun funds that emphasise on large cap stocks. As long as the rally in small cap stocks continues, such funds will continue to outperform other funds.
In spite of that, investors should be aware that funds which focus their investment in small cap stocks may see considerably higher volatility of returns when small cap stocks retrace and when the market sentiment for small cap stocks turns negative.
The end of the rally in small cap stocks generally signals the start of a period of consolidation in the overall market. As small cap stocks tend to have a lower level of stock trading liquidity and a smaller base of institutional holdings, their price performance are inclined to be more volatile during periods of market uncertainty. In comparison, the price performance of large cap stocks is generally more stable during periods of market weakness as buying support from institutional investors will emerge as and when these stocks fall to valuations which are deemed attractive. In this case, investors who have a preference for more consistent fund returns over the long-term should invest in funds that focus a larger proportion of their portfolios in large cap stocks with more resilient earnings prospects.
This article is prepared solely for educational and awareness purposes and should not be construed as an offer or a solicitation of an offer to purchase or subscribe to products offered by Public Mutual. No representation or warranty is made by Public Mutual, nor is there acceptance of any responsibility or liability as to the accuracy, completeness or correctness of the information contained herein.