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Small-Cap Investors Face the Market
Fear of a pandemic caused by the coronavirus is gripping the markets. Even the S&P 500, which has been among the most bulletproof of all asset classes, dropped significantly.
In the midst of this, U.S. small-cap stocks, as represented by the Russell 2000 index, have taken an even harder beating.
In fact, in late February, small-cap stocks in the U.S. (represented by the exchange-traded fund IWM) were down more than twice as much year-to-date as large caps (represented by the ETF IVV) and were sporting a negative return over the past 12 months versus the S&P 500’s 13%.
Unfortunately for investors in small-cap stocks, this tale of underperformance is not a new one. Over the past three years, returns in small caps are lagging large caps by almost 7% per year. Over the past five years, the lag narrows but to a still substantial 4% per year. There’ve been few glimmers of optimism for investors betting on a turnaround as small caps have lagged the S&P over each of the past three years.
Diversification has been called the only free lunch in investing because it allows investors to simultaneously increase returns while not taking on a greater degree of risk in their portfolio.
But given that all stocks tend to move together in similar directions as well as the degree of underformance, does it even make sense for investors to diversify the stock exposure into small-cap stocks, waiting around for them to regain their footing?
In the late 1970s, researchers first identified the benefits of diversifying away from large-cap stocks by investing in their smaller counterparts. According to Ibbotson and Associates, small-cap stocks have returned 11.8% per year from 1926 through 2018. This compares to 10% per year for large caps.
That extra 1.8% became known as the size premium.
Over the past decades, incorporating small caps into your diversified investment portfolio became a well-accepted way to enhance the returns. Through low cost-indexing and brokerages with free (or nearly so) trading costs, getting access to this asset class has never been easier.
Yet investors betting on the payoff of that size premium are being asked to stomach one of the more difficult stretches of underperformance.
While it’s hard imagining small caps regaining their momentum against market leaders like Amazon.com (AMZN), Apple (AAPL) and Microsoft Corp. (MSFT), there are a few reasons why small-cap stocks could outperform from here.
For one, the earnings and revenue of small-cap stocks are more closely linked to the performance of the domestic economy. While firms having exposure to higher-growing emerging economies is generally seen as a positive, the scare of recent events like trade disputes and coronavirus has opened investors’ eyes to the vulnerability of a global supply chain disruption of large, multinational companies.
Secondly, across several key valuation metrics, small-cap stocks trade much cheaper than their large-cap counterparts.
For example, the Russell 2000 trades at 6.6x cash flow and has a price-sales ratio of 1x, while the S&P 500 trades at nearly twice that at 11.9x cash flow and a price-sales ratio of 2x. This is not a guarantee small caps will outperform, but it certainly is telling you expectations for them might be much lower, and therefore easier to surprise on the upside.
Lastly, the S&P 500 is significantly more concentrated with its top 10 holdings comprising 24% of the index. On the other hand, the Russell 2000’s top 10 weighting is only 3%.
While having more concentrated exposure to stocks like Microsoft and Apple has no doubt been a great problem to have in recent years, investor returns in large caps going forward will become more highly dependent on fewer stocks.
Remember that if an investment in your portfolio is causing too much pain, it could mean several things. The most obvious one is you could have too much of it.
Small-cap stocks only represent 5% to 8% of the total U.S. stock market. If you have a 20% to 30% weighting, you’re definitely making a big bet on small caps. When you’re wrong, which has been the case, you’re definitely going to feel it and possibly make the bad decision of selling at the wrong time.
Secondly, you may need to familiarize yourself with market history. Entire asset classes and strategies will often spend long periods, a decade or more, going nowhere.
Lastly, past returns are no guarantee of future results. Just because small caps have done better nearly over the past century of market history, that doesn’t mean they are entitled to the same privileged status going forward.
The trend of underperformance has happened for a reason, and the emergence of winner-take-all markets like smartphones, search and social networks could mean the stocks of bigger companies are likely to continue to dominate at the expense of others.
While it’s impossible to know if or when that tide will turn in favor of small caps, it often can feel the darkest right before dawn. Weak market returns are often followed by even longer periods of extremely high returns.
While one certainly can’t say that small caps have done terribly over the past three to five years, the relentlessness of the underperformance could herald a reversion back to higher returns.
