Written by our Director of Equity Advisory, Jeremy McKeown, the HyperNormalTimes provides in-depth and considered long-term commentary on major macroeconomic and market-shaping themes.

<< Back to HyperNormalTimes archive

January 29, 2023

Small Cap Effect – Dead or Resting?


Owner: (Michael Palin) Oh yes, the, uh, the Norwegian Blue…What’s,uh…What’s wrong with it? 

Mr. Praline: (John Cleese) I’ll tell you what’s wrong with it, my lad. ‘E’s dead, that’s what’s wrong with it!

Owner: No, no, ‘e’s uh,…he’s resting. 

(Dead Parrot Sketch, Monty Python’s Flying Circus) 


Market Imperfection

In 1981 a Swiss German, Rolph Banz, published a PhD dissertation at the Chicago Business School on the study of “The Relationship Between Return and Market Value of Common Stocks.” Its findings flew in the face of the commonly held view among economists that financial markets were mainly “efficient”, an assumption that spawned Modern Portfolio Theory and the Capital Asset Pricing Model. Banz had demonstrated what became known as the Smaller Companies Effect. Simply put, over the long haul, smaller companies outperform larger companies. There followed studies across different stock markets that showed broadly similar annualised small-cap return premia of about 3%. While this might sound insignificant, the compounding effect is enormous. The small-cap effect is a highly profitable financial market imperfection, although its sustained existence remains in question.

Over Here Too 

In 1987 the UK, two professors at the London Business School, Paul Marsh and Elroy Dimson,  created what was known as the Hoare Govett Index and today is the Numis Smaller Companies Index (NSCI) which tracks the performance of the bottom ten percentile of the UK stock market by capitalisation. Today the NSCI is part of a comprehensive family of indices covering all listed companies in the UK from the largest to the smallest, with data going back to 1955. This data found that the long-term UK small-cap effect was similar to Rolph Banz’s findings for the US.

Turning Point

Although investing is a forward-looking endeavour, historic shape changes can provide clues about attractive investment opportunities. Long-term indices show how the market re-evaluates companies by size over time. Stock market structures change as relative values of small and large-cap stocks change. If Banz’s thesis remains intact, several critical factors indicate that increased relative returns can accrue to smaller UK companies over the next few years. In this context, 2022 is fascinating, a lousy year for nearly every asset class, particularly smaller companies.

Just Resting 

The Numis Indices: 2023 Annual Review illustrates that during 2022 the UK market was essentially stretched upwards by the massive outperformance of the ten largest mega-cap companies. Dominated by big oil, big pharma and big mining companies, this segment rose by 25% versus the NSCI, which fell by 18%. The Numis Large-Cap Index rose by 4%. The UK small cap minus large-cap premium over one year was negative 22%. Over three years, it is negative 4% and over five years negative 3%. Such is the absence of a small cap effect over the last few years; commentators are questioning whether it is still alive.

Shape Shifting 

The shape-shifting of mega-caps versus smaller caps has sharply increased the number of companies in the NSCI. These “fallen angels” number 29 entrants into the NSCI, representing 26% of the index value and materially reducing the trailing PE of the group from 17x in January 2022 to just 8x in January 2023. A large cohort of fallen angels, a prolonged (5-year) period of negative returns relative to large-cap stocks and the low PE valuation relative to larger companies are all significant. If anything can revive Banz’s small-cap effect in the UK, it is these three critical factors.

Fallen Angels

Since 1956 the returns to buying the NSCI fallen angels of the previous year have averaged slightly negative. However, the returns are significantly positive when the fallen angel cohort is substantial and follows a sharp decline in markets like today. This year’s 29 fallen angels have already outperformed the broader market year to date by about 10%, indicating that 2023 might be the year of the fallen angel.

Concentration & Volatility 

Small-cap effect studies in different markets show that the most pronounced positive small-cap returns arise after periods of heightened market concentration and volatility. The three stand-out periods of small-cap outperformance in the UK over the last 65 years are 1975, 1998 and 2009. All these years came with significant structural shifts in the world economy and significant leadership changes in market sectors. Today feels like such a time.

Relative Valuation 

Partly due to the influx of lower-rated fallen angels into the NSCI  for 2023, the relative value of UK smaller companies compared to large-cap companies has been lower only on three previous occasions since 1980. Previously all these periods were followed by a year of meaningful small-cap revaluation, with the low point in 1998 seeing the biggest-ever small-cap rally lasting until 2007.

Dead or Alive 

As we know, past performance provides no guide to future returns. However, history does have a habit of offering the odd rhyming couplet. Rolph Banz’s 1981 revelation may have gone the way of the Norwegian Blue. It looked that way in the decade to 1998, when the small-cap effect went into long-term hibernation. Indeed if that period is today’s analogue, we must endure another five years of small-cap underperformance. However, if history proves any guide, the small-cap effect will return and display its beautiful plumage soon.


This communication is provided for information purposes only, and is not a solicitation or inducement to buy, sell, subscribe, or underwrite securities or units. Investors should seek advice from an Independent Financial Adviser or regulated stockbroker before making any investment decisions. Progressive Equity Research Ltd (“PERL”) does not make investment recommendations.

Opinions contained in this communication represent those of PERL and/or our affiliates at the time of publication and PERL does not undertake to provide updates to any opinions or views expressed. PERL does not hold any positions in the securities mentioned in this communication, however, PERL’s directors, officers, employees, contractors and affiliates may hold a position,  and/or may perform services or solicit business from, any of the companies or related securities mentioned.

Any prices quoted in our research are as at the previous day’s close.