Small Cap, Family owned and value, a recipe for succes?

In my investments, I have a preference for small family businesses that also trade cheaply. It is generally assumed that both small caps and family businesses perform better in the long term on the stock market. The same is said of the value factor. So, could this be anything other than a recipe for success? But are all these factors really so decisive?

How do we define these?

Small caps are often defined as companies with a market capitalization between $200 million and $2 billion. Below $200 million, we find micro-caps or even nano-caps. I'm not averse to such a micro-cap if an opportunity arises.

Above this, we first find mid-caps between $2 billion and $10 billion, and above that, we speak of large caps.

We define family businesses as companies where decisions are influenced by a strategic shareholder or family. This can range from the founding family to later shareholders, such as in the case of Deceuninck, for example. This can vary from very small companies to the largest companies in the world. Meta (Facebook) is also still a family business with Mark Zuckerberg owning more than 13% of the company.

The percentage of shares in the company plays less of a role than the influence the family has on the strategic decisions of the company, the corporate culture, and the value it places on the long-term survival of the company over short-term profit.

Value stocks are stocks that trade cheaper than their intrinsic value. In modern value investing, this intrinsic value is calculated based on what the company can generate (cash flows) in the future. However, when looking at the studies on this, or when it's used as a factor in an ETF, they refer to stocks that trade cheaply based on simple factors such as price-to-earnings ratio or price-to-book value, also known as multiples.

Do they outperform?

Small Caps

It is generally believed that small caps outperform large caps in the long term. This began with the study by Fama & French in 1997, which examined both company size and the value factor. According to this study, small caps outperformed large caps by an average of 3.1% annually between 1927 and 1981.

Furthermore, the study by Ibbotson Associates is also well-known, which found that small caps significantly outperformed large caps since 1926, even during periods of recession and corrections. The theory is that small companies recover faster and experience higher growth after a recession.

A study by Switzer in 2010 titled "The Behavior of Small Cap vs. Large Cap Stocks in Recessions and Recoveries: Empirical Evidence for the United States and Canada" confirms this assertion, but nuances that this is not valid in all regions or periods.

In Europe, the results are even more mixed according to the study by Dimson, Marsh, and Staunton from 2004 titled "Low-Cap and Low-Rated Companies". In various European countries, large caps performed better.

Even through ETFs, it was found that small caps outperformed large caps according to the study by G. Rompotis in 2019 titled "Large-cap vs small-cap portfolio performance: new empirical evidence from ETFs".

But then there is also the article in Financier Worldwide, "A quick review of the literature regarding the small cap premium" from 2017. In this, Aswath Damodaran, an authority in company valuation, argues that this small-cap premium is not as certain as it seems. Between 1978 and 2013, the Russell 2000 index achieved nearly the same return as larger companies, namely 12%. In the period between 1926 and 2012, there would have been an outperformance of an average of 1.8% per year, but this was accompanied by a change in legislation that opened the door for funds to invest in smaller companies between 1975 and 1983. If we filter these out, we get a similar return of about 8%.

Damodaran also notes that if we exclude stocks with a market capitalization of less than $5 million from the studies, the effect also disappears. So, we should actually be talking about a nano-cap premium instead of a small-cap premium.

Family businesses

There are also numerous studies on the performance of family businesses indicating that they outperform their counterparts not under family control. According to a study by Credit Suisse and Boston Consulting Group, family businesses achieve higher returns, thus performing better on the stock market. Particularly, their long-term vision, lower debt levels, and focus on quality and sustainability are differentiating factors.

The study by Anderson & Reeb from 2003, titled "Founding-Family Ownership and Firm Performance: Evidence from the S&P 500," suggests that the effect is indeed present when the CEO comes from the founding family.

A similar correlation has been found in Germany. When the founding family holds a controlling position in management or the board of directors, it leads to better returns, both for the company and on the stock market (Large shareholders and firm performance--An empirical examination of founding-family ownership, C. Andres, 2008).

In a study on family businesses in the United Kingdom, Poutziouris, Savva, and Hadjielias reached a different conclusion in 2015. There indeed seems to be a positive factor for family businesses as long as the family's stake does not become too large. Once the family's stake exceeds 31%, the positive effect diminishes, likely due to governance issues (Family involvement and firm performance: Evidence from UK listed firms).

Villalonga and Amit concluded in their study "How Do Family Ownership, Control, and Management Affect Firm Value?" that within Fortune 500 companies, the combination of a founder as CEO or founder and chairman of the board is ideal. Conversely, if descendants of the founder come into power, there is a high likelihood that they will destroy value.

Value stocks

When it comes to value stocks, we also refer back to the study by Fama & French, as mentioned earlier. Here too, this factor is said to outperform other factors such as growth in the long term.

However, we mainly find older studies, such as that of Bauman, Scott, Mitchel & Miller from 1998, titled "Growth versus Value and Large-Cap versus Small-Cap Stocks in International Markets". In this study, they identify a consistent pattern across 21 countries over ten-year periods where the value factor outperforms the growth factor, both in total return and risk-weighted.

Even between 1999 and 2014, the value factor was the best-performing factor on the American stock market according to the study by Chongsoo An, J. Cheh, Il-woon Kim 2017: "Do Value Stocks Outperform Growth Stocks in the U.S. Stock Market?" This study finds these better performances across small, mid, and large caps.

A recent study on the Korean stock market found no better performance with the value factor, while another study for India observed a very strong effect.

However, in "Performance of Value and Growth Stocks in the Aftermath of the Global Financial Crisis" by Lea-Marija Bevanda, A. Zaimovic, Almira Arnaut-Berilo from December 2021, we find that since the financial crisis of 2008-2009, the growth factor has outperformed the value factor. The dominance of the growth factor is said to stem not only from the strong performance of technology companies but also from the very low interest rates.

In "Value’s Death May Be Greatly Exaggerated" by R. Arnott, Campbell R. Harvey, and Vitali Kalesnik from 2020, we can conclude that these lesser performances result from the fact that the intangible aspects of companies are not adequately reflected in the classic value factors.

Logical reasons for outperformance

Although studies for all three of these factors provide conflicting signals, there are logical explanations as to why some stocks within these segments outperform their counterparts.

For small caps, for instance, growth potential is a significant factor. It's logical that generally smaller companies have more room to grow and can do so more rapidly. These companies are more flexible and can anticipate opportunities more easily than their larger counterparts, which often fall prey to bureaucracy. They can adjust strategies more readily and better serve niche markets, all resulting in faster growth and consequently better returns for investors.

Additionally, they are often less closely followed by the market. Few analysts are tracking these companies, meaning positive developments often remain hidden for longer. Consequently, they are also attractive targets for acquisitions by larger companies looking to enter a new niche, increase their market share, or simply acquire new technology.

For family businesses, factors such as long-term vision, strong corporate culture, and employee loyalty are significant. Additionally, their cautious approach to debt and reputation instills confidence in both customers and investors.

Similarly to small caps, most family businesses benefit from a more streamlined decision-making chain, often firmly in the hands of the family, making everything faster and more efficient.

Regarding value stocks, counter-cyclical investments in opposite cyclic movements are one of the explanations. Because markets are not efficient and temporary short-term problems are often extrapolated into the future, companies can become undervalued unfairly. These two factors allow vigilant investors who do their homework to capitalize on these misvaluations.

Furthermore, if these companies continue to perform, we often enjoy a stable and relatively high dividend income to make the waiting time bearable. And even if not everything goes as planned, you have a margin of safety, that might be big enough so you don’t have to take a loss.

Not without risk

Of course, these segments are not without risks either. For instance, smaller companies are often much more volatile and will be the first to tumble during a recession. Due to their smaller size, they are also more sensitive to an economic slowdown, especially if they operate in a very specific niche.

When it comes to family businesses, we immediately think of nepotism. Is the successor the suitable candidate, or are they only the successor because they are a descendant of the founder? To what extent do they consider the minority shareholders when running the company, and how do they balance the needs of the company with those of the family?

And then there are the potential family disputes that can arise during succession, which can hinder and delay progress and decisions for years, sometimes with disastrous consequences.

Regarding value stocks, it's challenging to determine whether the company is rightly cheap or not. Are the problems as temporary as we think? Are there any obligations, risks, or debts that are not visible on the balance sheet, such as those related to poor products, issues in the production process, or similar?

Moreover, these stocks can remain cheap for years. Not only must you as an investor be convinced to hold onto these stocks, but every additional period it takes for the market to recognize their value weighs on your returns.

Conclusion

Investing in small caps, family businesses, and value stocks requires a good understanding of the unique characteristics of each of these segments and what drives better returns within these segments. Combining these factors is therefore not an instant recipe for success. Not only can the positive factors reinforce each other, but the negative factors can also do the same, leading to very weak stock market performance.

Success in these market segments is achieved through careful research, sufficient - but not excessive - diversification, and a long-term investment horizon. The allure of higher returns from these factors is strong, but successful execution requires a balance between optimism and caution. And then there's, of course, the quality factor to consider adding.

We saw in the studies that none of these factors always led to outperformance, but especially in certain periods. If we then consider that since 2009, growth, and more specifically large growth companies, have dominated, I dare to assume that this tide will turn and that smaller value stocks may be at a turning point to take over dominance in returns for the coming years.