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Long Story Short: Large and Small Caps Return Probabilities
Long Term Investors and Small Cap Stocks
(Note: companies that could be impacted by the content of this article are listed at the base of the story [desktop version]. This article uses third-party references to provide a bullish, bearish, and balanced point of view; sources are listed after the Balanced section.)
According to Ibbotson Associates’ Stocks, Bonds, Bill and Inflation, small Capitalization stocks outperform Large Capitalization stocks over the long term. (Although there is not a set definition for a Small Cap stock, generally speaking Small Cap stocks are those with a market capitalization below $2 billion today, while Large Cap stocks refer to the S&P 500.) Over the 1926-2018 period, Small Caps produced an average annual return of 11.0% compared to 9.99% for Large Capitalization stocks. (1) But, since 2010, Small Cap stocks have underperformed their Large Cap brethren. From the beginning of 2010 through the end of 2019 the S&P 500 rose 185.2% while the Russell 2000 (a proxy for small cap stocks) was up 145.8%. Over the last decade, the S&P 500 outperformed the Russell 2000 in 6 of the ten years. In 2019, the S&P 500 produced a 28.9% return compared to 23.7% for the Russell 2000. Has the time come for Small Cap stocks to outperform Large Cap stocks?
Attractive Relative Valuation Levels. Valuations for Small Caps are at their most attractive levels since June 2003 relative to Large Caps, according to data from Jefferies Financial Group. Historically, Small Caps have outperformed Large Caps by an average of 6% over the following year when the valuation gaps widen this much. (2)
New Index Highs Are a Historic Positive Sign. This past Thanksgiving, the Russell 2000 hit a new 52-week high after nearly 15 months without breaching it. FactSet and LPL Research data indicate that of the last 11 times the Russell 2000 index hit a new 52-week high, returns for the index were up an average 17% over the next 12 months 10 of those times. (3)
Higher Rate of Earnings Growth. Small Cap stocks produce a higher rate of earnings growth over time than Large Caps. Over the 1987-2017 period, Small Caps average annual recurring earnings growth was 8.15% versus 7.44% for Large Caps. (4)
Positives of Small Caps. As one would expect, most Small Caps are young companies with less international exposure than Large Caps. (5) Small Caps have less research coverage than Large Caps, providing a greater potential of market inefficiencies. (6) Ownership of Small Cap stock is typically concentrated in the hands of founders or management, a group that may be more motivated to increase shareholder value than the highly dispersed ownership of Large Cap shares.
Higher Returns are due to Higher Risk. According to Alpha Wealth Strategies, Small Caps higher return over time comes with a standard deviation (a measure of risk) of 31.28 compared to just 19.76 for Large Cap stocks. (7) So, yes, an investor is receiving a higher return over time from Small Cap stocks, but the investor is assuming higher risk to achieve those returns.
Greater Volatility. As an example of the greater volatility of Small Caps, the Russell 2000 posted 65 intraday moves of 1% or more in the first 10 months of 2019, double that of the S&P 500. (2)
More Susceptible to Economic Shocks. Given their smaller size, lack of business diversification, and limited access to capital, Small Cap companies have historically been more susceptible to economic shocks. In times of economic uncertainty, many investors flock to Lage Cap stocks that are easier to trade and do not suffer from Small Caps’ business limitations. (8)
Small Caps Risks Relative to Large Caps. Among the greater risks of Small Caps is they tend to be more leveraged than Large Cap stocks with less operational efficiency and pricing power. (3) Small Caps also typically have less liquidity than Large Caps, meaning it may be tougher for investors to either build a position or quickly exit a holding. (6)
While Small Cap stocks make up roughly just 10% of the overall U.S. equity market capitalization, they constitute the vast majority of publicly traded firms. And while Small Cap stocks are more volatile than Large Cap stock, over the last 93 years Small Caps generated positive returns in 68% of the years, compared to 73% of the time for Large Caps. Over the period, Small Caps produced a best one-year return of 142.87% and a 1-year worst return of a negative 58.01%, compared to 53.99% and a negative 43.34% for Large Caps. (7) Given Small Caps superior long-term investment returns compared to Large Caps, Small Caps would appear to be fertile shopping ground for long-term oriented investors.
- https://www.cnbc.com/2019/10/09/small-caps-are-primed-to-outperform-large-caps-over-the-next-decade.html, Fred Imbert, October 9, 2019
- https://fortune.com/2019/12/03/as-small-cap-stocks-hit-new-highs-some-see-evidence-that-the-bull-market-has-more-room-to-run/, Anne Sraders, December 3, 2019
- https://fp.thriventfunds.com/insights/market-updates/whats-behind-the-underperformance-of-small-cap-stocks.html, Matthew Finn, October 22, 2019
- https://money.usnews.com/investing/portfolio-management/articles/how-to-compare-small-caps-vs-large-caps-for-your-portfolio, Ellen Chang, December 5, 2019
- https://www.cnbc.com/2019/08/13/small-cap-stocks-are-tanking-while-large-caps-hold-up-a-signal-something-is-wrong-with-economy.html, Maggie Fitzgerald, August 13, 2019