Small and mid-cap stocks have underperformed large-cap stocks for over a decade. Is now the time to increase your allocation?
Topics covered include:
- How big are small and mid-cap stocks
- How have small and mid-cap stocks performed relative to large cap stocks
- How have active small and mid-cap managers performed relative to indexing options
- Are bigger IPOs contributing to small and mid-cap stocks underperformance
- How expensive or cheap are small-cap stocks relative to large-cap
- What is the capital asset pricing model and how do academics use it to identify outperforming factors
- How value, momentum, and quality drive small-cap stock outperformance
- How to invest in small and mid-cap stocks
The Morningstar Active/Passive Barometer
Initial Public Offerings: Updated Statistics January 5, 2022, by Jay R. Ritter—Warrington College of Business, University of Florida
The Nexus of Anomalies-Stock Returns-Asset Pricing Models: The International Evidence by Rahul Roy and Shijin Santhakumar
The Cross-Section of Stock Returns before 1926 (And Beyond) by Guido Baltussen, Bart van Vliet, and Pim van Vliet
Factor Timing: Keep It Simple by Michael Aked—Research Affiliates
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Welcome to Money For the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I’m your host, David Stein. Today’s episode, 370. It’s titled “Should you invest in small and in mid-cap stocks?”
I recently got two emails from members of Money For the Rest of Us Plus asking about investing in smaller and mid-sized companies.
These companies are called small-cap and mid-cap. And cap stands for capitalization. Which is a measure of the size of a publicly-traded company. Capitalization is measured by the number of stock shares outstanding times the prices.
One of these members sent me a detailed spreadsheet that had performance, taken from Morningstar, of a number of different ETFs, comparing large-cap U.S. stocks, small-cap stocks, mid-cap, growth, value, momentum. I won’t get into all that data, but one of the things is clear—over the past decade, large-company stocks have been fairly consistently outperforming small company stocks. If we go back over the past decade, small-cap stocks have only outperformed large-cap stocks on an annual basis four times. And mid-cap stocks have outperformed large-cap stocks only three times over the past decade.
The other members were looking at the performance of mid-cap stocks versus large company stocks, and their question is the same—has something fundamentally changed to which a large company stock will consistently outperform mid-cap and small-cap stocks going forward? We’re going to explore that question in today’s episode.
Differences Between Small, Mid, and Large-Cap
Let’s first look at what the differences are between small-cap, mid-cap, and large-cap. Again, we’re looking at market capitalization. Small-cap stocks are typically stocks that have a market capitalization between 300 million and two billion dollars. Mid-cap stocks have a market cap between two billion and ten billion. And then large-cap stocks would be stocks above ten billion.
Now, these are not firm rules. Every vendor index provider has different criteria. For example, the S&P 400 Mid-Cap Index includes stocks with market capitalizations between 3.6 billion and 13.1 billion. Vanguard has different classifications. They consider small-cap anything less than 6.5 billion, and medium-small to be between 6.5 and 14 billion. If we use Vanguard’s classification, about 7.4% of U.S. stocks, based on market capitalization or size—and that’s what market cap is, it’s really the size of the companies or the segment of the market as a percent of the total market—about 7.5% of the U.S. stock market is really in that small/mid category of less than 6.5 billion dollars. And another 6% or so would be between 6,5 and 14 billion dollars.
As an institutional investment advisor, I got into that profession in the mid-’90s, and our typical client was a university endowment, and I could go across many, many of our clients, and they had similar portfolios. This was before there was a lot of allocation to private investments or alternative investments. A typical portfolio at that time would have 40% in U.S. large-cap stocks, 10%–15% in U.S. small-cap stocks, 15% to 20% in non-U.S. stocks, and then 30% in bonds. So 70% stocks, 30% bonds, and generally there was an overweight to small-cap.
If we allocate 10% to 15% of the total portfolio to small-cap as a percent of the equity portfolio, it would have more than double the weight in small-cap versus the major indices? Why did we do that? We did it because we thought small-cap would outperform, and that we could identify stock
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