Why have global small-cap stocks underperformed large-cap stocks and will the trend continue? The investment case for allocating to global small caps.
Topics covered include:
- How have small caps performed relative to large caps over the past two decades
- What factors contributed to the underperformance
- How quality is an important factor to consider when investing in small caps
- What are the earnings prospects for small-cap stocks
- Why small-cap stocks could deliver double-digit returns over the next decade
Show Notes
Small stocks, big problems by Robin Wigglesworth—The Financial Times
The Death of Small Cap Equities? by Chris Satterthwaite—Verdad
The Quality of New Entrants by Chris Satterthwaite—Verdad
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Transcript
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 is episode 476. It’s titled “Is Small-Cap Dead? Why You Shouldn’t Abandon Small Company Stocks.”
Just over two years ago, in January 2022, we released episode 370, “Should You Invest in Small-Cap and Mid-Cap Stocks?” Small-cap and mid-cap—the cap stands for capitalization, which measures the size of a publicly-traded company. Capitalization is measured by the number of stock shares outstanding, times the price.
Small-cap stocks are typically those that have a market capitalization between 300 million and 2 billion, although it can vary. Some take that upper range a little higher. For example, one of the studies that we’ll refer to in this episode took it all the way up to 4 billion, which some would say is a mid-cap. Mid-cap is typically between 2 billion and 10 billion, and then large-cap stocks would be above 10 billion. But there are no set rules. These are just broad ranges.
Performance of Small-Cap Stocks
Now, it turns out January 2022 wasn’t a great time to increase one’s allocation to small-cap. Global and US small-cap stocks lagged global and US large-cap stocks by about 3% annualized over the past two years. The one exception though is emerging markets small-cap stocks actually outperformed emerging markets. Emerging markets small-cap returned 3.4% annualized from the end of January 2022 through March 2024, while the overall emerging markets declined -4% annualized
As an institutional investment advisor—I began that in the mid-1990s; we would have these university clients, we would do an asset allocation study using modern portfolio theory. And invariably, we would recommend allocating 15% to 20% of the publicly traded stock portfolio to small-cap stocks.
Why? Because it showed that the returns were higher, and there were some diversification benefits. So by adding small-cap stocks, we could increase the expected return of the portfolio without much of an increase in the expected volatility as measured by standard deviation.
At that point, we would do manager researches, we typically would use active managers at that time, and we would do a search for a small-cap value manager, and small-cap growth managers. We’d bring in two or three to be interviewed by the Investment Committee, and then they would select their new small-cap managers.
Now, that was the approach, and the whole idea was small-cap will outperform large-cap because they have. Partly because their earnings grow faster. There’s an argument—and academics would make this—because they’re more volatile, small-cap stocks, that they should generate a higher return to compensate for that risk.
If we go back 20 years—and this is data from Asset Camp—we have a brand new return summary table that we included in our latest update—we can see that global stocks returned 7.8% annualized for the 20 years ending March 2024, while global small-cap stocks returned 8.2% annualized.
So small-cap has continued to outperform over that 20-year period for global. The same for World Ex US. World Ex US small-cap outperformed World Ex US, which is mostly large and some mid, by about 0.7% annualized over the past two decades.
Emerging markets small-cap stocks have outperformed the overall emerging markets by 1.8% annualized over the past two decades. The one exception though is the US. US small-cap stocks returned 8.8% annualized over the past two decades, while US large, including some mid, returned 9.6% annualized. These are all MSCI indexes.
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