While “style boxing” (e.g., large cap vs. small cap, growth vs. value, etc.) often seems like another attempt by Wall Street to make what is already hard (investing) more mystical and, consequently, more expensive for clients, the recent hype about advantages of small-cap investing is not without merit. However, most attempts to deliver the story are simply incomplete, or incorrect.
It is not enough to compare index performance, for example the S&P 500 vs. the Russell 2000 (the most common proxies for U.S. large- and small-cap stocks). On this basis, small-cap stocks have outperformed higher capitalized listings in the long-run, but only possibly from the perspective of a real investor. The flaw is in the index design itself, as both indices are constructed based on market capitalization, therefore assigning a greater significance, or higher attribution to index performance, to companies with larger market caps. Think of it this way: currently, the S&P 500’s highest allocation is to Apple, with 4 percent, compared to Pfizer, as the 10th largest position, with only 1.17 percent. If stocks were held by standard of equal weight in index construction, the argument of small-cap stocks outperforming large caps would dwindle in the long-run, at least by pure index comparison.
Our argument leaves us with some early conclusions. Not only is it important to buy the “right” small cap stock, likely through active stock selection rather than indexing, but it is also important to more precisely formulate the investment thesis pro and con small caps, and to define trigger points for a “crossover,” meaning when to overweight small vs. large and vice versa.
Considering the current investment environment, it is difficult to perceive how large multi-national U.S. companies will further secure their pricing advantages in global markets, as about 46 percent of profits in the S&P 500 are derived abroad. With this in mind, it does not help that the U.S. dollar has strengthened considerably, and that most of the world is showing subpar economic growth. On the other side of the argument is a strengthening U.S. economy, usually supportive of more domestically-focused small companies. During periods of dollar strength (15 percent and more), small-cap stocks have outperformed their large-cap peers by 3 percent annually. Even in a rising rate environment, which could impact attractive financial conditions for smaller companies, performance was 2.5 percent higher vs large-cap stocks (since 1993; comparisons using S&P 500 vs. Russell 2000 cap-weighted indices).
Further, in my view, small- and micro-cap stocks can be considered as the next best option to illiquid private-equity, which typically receives a return premium over comparable liquid investments. Keeping my hypothesis in mind, outperformance of small-cap stocks is more pronounced over extended periods of time, especially when accounting for inherent volatility. Research conducted over a 70-year data series shows that the benefit of small-cap investing may not manifest itself unless the investment horizon is in excess of 15-20 years. Also, at the sector level, investors can capture excess returns in small caps when the accompanying large-cap sector is outperforming the broad market - but sector selection is vital, as, historically, the consumer and financial sectors delivered the least consistent outperformance.
Small-cap stocks will likely produce better results for investors with a stomach for volatility paired with a long time-horizon. Quite surprisingly, timing, as a much “shunned” allocation practice, can to a degree be applied when determining the right mix of small-cap vs large-cap equities, with periods of economic expansion benefiting smaller companies (at least in the U.S.). The globally-minded investor should note that the small-cap story is not a “U.S. exclusive,” but can be applied across borders.
The bottom line: with many investors still expressing discomfort regarding equity investing in the first place, it may not be a disadvantage to simply forgo an allocation to larger companies (or, at a minimum, only apply a simple indexing approach), and focus on the right “hand-picked” small-cap exposure to capture excess market returns. On this basis, concerns related to volatile market periods should be compensated appropriately.
Matthias Paul Kuhlmey is a Partner and Head of Global Investment Solutions (GIS) at HighTower Advisors. He serves as wealth manager to High Net Worth and Ultra-High Net Worth Individuals, Family Offices, and Institutions.