Think Small Not Big

June 7, 2020

Stocks that have a smaller total market value (small cap) have been underperforming stocks with larger market values (large cap) for many years, which is the opposite of what is generally expected. The trend has been big cap’s friend. When will it end?

The Theory is Bleary

The thinking is that small cap companies should have more room to grow and be quicker to realize opportunities than their larger counterparts. In addition, the prices of small cap stocks have been more volatile than large cap stocks, so investors should get rewarded for that extra risk over time. The theory has worked over the exceedingly long run, as small cap U.S. stocks returned 11.4% annualized since 1927 versus 9.7% for large cap[1]. But for horizons less than 90 years, the theory doesn’t always hold. 

Relative Rollercoaster

Chart 1 plots the monthly total return of the Russell 2000 Index versus the total return of the Russell 1000 Index since its inception in 1978[2].  The Russell 2000 Index tracks the smallest 2000 stocks in its universe of 3000 stocks, while the Russell 1000 tracks the largest 1000 stocks. When the ratio is rising small cap is outperforming large cap (green up arrows) and when the ratio is falling small caps are underperforming (red down arrows). Although the Russell 2000 small cap index has underperformed the Russell 1000 large cap index by an annualized 1% over the last 40 years, there has been four periods of significant outperformance along the way.

Chart 1

Source: FTSE Russell, Morningstar

Almost Red Alert

Similar to what I showed in the previous blog (Red Alert: Value is Value), the Red Zone in Chart 1 indicates the few times (5% of the data) that the ratio of small cap to large cap has been as low as today. Small cap reached its worst point versus large cap in the tech bubble, when the ratio fell to 0.6. The latest reading of 0.7 at the end of May is close to the Red Zone, ranking small cap versus large cap in the cheapest 6% of all the monthly data. I say that is close enough! Small cap has underperformed large cap for 9 years, the longest period since the 7 years of underperformance from 1983 to 1990.

Small Expectations

So where do we go from here?  In Chart 2 I look at the same monthly data, but with an overlay of the times when there has been a recession (grey bars). This is where it gets interesting. While the sample size isn’t big, small cap has outperformed large cap (green up arrows) coming out of the previous 5 recessions. Going into a recession, the median is for small cap to underperform in the first 3 months. From the trough, the median length of time that small cap outperforms large cap is about 3 years, with a range of under 1 year (1980 recession) to over 6 years (2000 recession). So that is interesting, but what about returns? From the trough, the median outperformance of small cap over large cap is a cumulative 42%.  I am sure you will agree that is a big number.

Chart 2

Source: FTSE Russell, Morningstar, National Bureau of Economic Research

What does this all say about where we are today?  In Chart 2 the grey shadings show that I have assumed that the 2020 recession started in March. The trough in small cap performance versus large cap so far was also in March. While this recession is different, and companies will continue to be affected by Covid-19, history tells us that this is just the beginning of a trend of small cap outperforming large cap.

Invest Wisely,

Dave Schaffner, CFA

Principal, Wayfairer Capital Management Ltd.

[1] Based on Fama/French data available at http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html, comparing the returns of the bottom 30% of U.S. stocks by size to the top 30%.

[2] Similar results are obtained by using the ratio of IWM, the iShares Russell 2000 ETF, versus IWB, the iShares Russell 1000 ETF, but there is less history as the ETFs were launched in May 2000.