Small Caps: The Good, Bad and the Ugly

posted in: Other | 0, Fall, 2014. This article was written with Jim Cahn, the Chief Investment Officer at Wealth Enhancement Group. It was part of a series of articles developed under an agreement with Forbes to work with a variety of contributors and assist them in delivering actionable investment ideas each week. The site is one of the top 500 sites in the world with nearly 10 million subscribers and nearly 100 million page views a month.

U.S. Small Cap stocks have had an ugly year in 2014. U.S. Small Cap stocks (as measured by the Russell 2000 Index) trailed U.S. Large Cap U.S. stocks (as measured by the S&P 500 Index) by 10% [as of 10/28/2014]. Investors with a well-diversified portfolio—which includes small caps—have watched their returns trail major market indexes.

It wasn’t supposed to be this way.

In 1992, Nobel Prize winner Eugene Fama and Ken French published their important paper “The Cross-Section of Expected Stock Returns,” which showed that U.S. Small Cap stocks tend to outperform the market over time.

The catch? The relative outperformance of U.S. Small Cap stocks started to shrink in the early 1980s, which may be partially explained by the creation of the first Small Cap mutual funds. Nevertheless, the paper showed that a subset of Small Cap stocks, Small Cap Value (think RLG Lodging Trust), tended to outperform just about every other market segment with the exception of the very best category, Small Cap Momentum (think Puma Biotechnology ).

The underperformance of Small Cap Value and Small Cap Momentum is rare.

Looking back from January 1927 to August 2014, Small Cap Value stocks beat Large Cap Growth stocks by 6.24% annually. Over that same period, the premium to Small Cap Value was positive over 99% of 10-year rolling periods. Small Cap Momentum stocks beat Large Cap Blend stocks 7.63% annually. The Small Cap Momentum premium was positive approximately 84% of 10-year rolling periods.

The greatest period of underperformance for Small Cap relative to Large Cap was during the deflation of the dot-com bubble. Similar to the late 1990s, but to a lesser extent, Small Cap stocks were relatively expensive (as compared to Large caps stocks) coming into 2014, but that valuation difference is now shrinking. Regardless of current valuation, long-term investors need to determine if the current selloff in U.S. Small Caps is one of these rare periods of underperformance—or if the markets have fundamentally changed.

I believe there is still a place for Small Cap stocks in portfolios, especially Small Cap Value and Small Cap Momentum. Here’s why:

  1. Greater Risk equals Greater Return: Small Cap stocks are riskier than Large Cap stocks. Small Cap stocks are small companies with less experienced management teams, limited access to capital markets and less diversified business lines. The higher risk inherent in Small Cap stocks should lead to greater return over time.
  2. They are underexplored: There might be some truth to the argument that since Small Cap stocks are small, these companies are ignored by the best and brightest securities analysts. While I believe markets are relatively efficient, such that if there were return to be had, analysts would focus on Small Cap stocks, the lack of transparency into small companies means it takes more time for information about the companies to embed itself into prices.
  3. Higher Value and Momentum Premiums: Research demonstrates that the returns to Value and Momentum tilts are higher in Small Cap stocks than Large Cap stocks. That means that over time, even if the returns of Small Caps and Large Caps are the same, tilting your Small Cap portfolio to Value and Momentum gives you a chance to outperform. The strength of the premiums may result from the time lag between new information and price changes, as discussed above.

The bottom line: While Small Cap stocks have had an ugly year, I believe that Small Cap stocks, especially Value and Momentum, are still viable options for diversified investors with longer time horizons.

Click here to see the article on Forbes.