Is Small Cap Dead? Why You Shouldn't Abandon Small Cap Stocks
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Welcome of 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 and your host David stein today is episode four seventy six. It's title is small captive, why you shouldn't abandon small companies stocks.

Just over two years ago, in january twenty two, we released top three seventy. Should you invest in small cap, mid cap stocks, small cap and midcap. 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 three hundred million and two billion. Although I can vary some, take that up, arrange a little higher.

For example, one of the studies that will refer to in this episode, de took IT all up to four billion, which some would say is a mid cap. Midcap is typically between two billion and ten billion, and then large cap stocks would be above ten billion. But there are no set rules.

These are just broad ranges. Now IT turns out january tone and twenty two wasn't a great time to increase one's allocation to small cap. Global N U S small cap stocks lag.

Global N U S. Large cap stocks buy about three percent analyzed over the past two years. The one exception, though is emerging markets. Small cap stocks actually outperformed emerging markets.

Are you markets small capital n three point four percent analyzed from the end of general twenty twenty two through march twenty twenty four, while the overall margin markets declined negative four percent analyzed as an institutional investment advisor, I began that in the bid one thousand nine hundred ninety. We would have these university clients, we would do an asset allocation study using modern portfolio theory. And invariably we would recommend allocating fifteen, the twenty percent of the publicly traded stock portfolio to small cap stocks.

why? Because IT show that the returns were higher and there was some diversion 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 searches. We typically would use active managers at that time, and we would do a search for a smoke at 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 in the whole idea was a smart cap will outperform large cap because they have partly because the earnings grow faster. There's an argument and academic would make this because there more volatile small cap stocks that they should generate a higher return to compensate for that risk if we go back twenty years. And this is data from asset camp of A A brand new return summary table that we included in latest stop date, we can see that global stocks returned seven point eight percent annualized for the twenty years ending march twenty, twenty four.

Well, global small cap stocks return to eight point two percent analysts. So small cap has continued to outperform over that twenty year period for global. The same for world X U S.

World X U S, small cap outperformed world X U, S, which is mostly large and some mid, by about zero point seven percent analyzed over the past two decades. Emerging markets small cap stocks have outperformed the overall emerging markets by one point eight percent analyzed over the past two decades. The one exception though is the us.

us. Small cap stocks return eight point eight percent analyzed over the past two decades. wow.

U. S. Large, including summit, returned nine point six percent analysts. These are all msci indexes.

There was an article in the financial times, which has done a number of articles recently on small cap stocks. One titled small stocks, big problems. The other was U. S. Small caps suffer worst run against largest stocks. And over twenty years now in that article, they pointed out that using the rest of two thousand small cap index, IT has now lagged behind the S M, P five hundred, a measure of large capus dogs since one nine hundred and seventy eight, which was the inception of the Russell two thousand. Since twenty twenty, the rest of two thousand has gained twenty four percent cumulative that ping small cap stocks significantly lagging the S M P five hundred, which returns sixty percent cumulative since twenty.

Greg torto is a small cap manager at goldman success, and management says, i've been investing in small caps for almost thirty years, and you haven't seen big money moving into the space since twenty sixteen or twenty seventeen. You need a little greed. You need some of those animal spirits, maybe a pickup in mergers and acquisitions or a booming IPO market for small cap stop to really take off.

We will take a look at why U. S. Small cap stocks have under performed over the past twenty years and certainly over the past ten and five.

But one reason that i've invested in small cap stocks for decades, and I recommended IT to institutional clients, was they do out perform and they have globally, they have an in the us, which will explore. But one reason is there's just less coverage of those stocks. S there are a fewer analyst on the the cell side of wall street covering small cap stocks.

Looking at the underlying fundamentals of the companies providing earnin's investments, golbin sax pointed out in the financial times article that the media small cap stock new has five analysts covering IT and one in seven small cap stocks has only one analyst or or no analyst covering the company all, but if you compare that to the media S P, five hundred stocks, eighteen analysts, and there are sixty six analysts covering microsoft because there's less coverage for small cap stocks. Greg torto of goon sex point sell when you get small caps, right? You're not right.

By twenty percent more than the street, meaning wall street, your earnings and revenue estimates could be double where the consensus is. That leads to a more significant Price game towards points out that the key to actively picking stocks, the current Price is the consensus, what the consensus of investors believe earnings will be in the future, what sales will be in the future, and theyve determined due to that, that this is the right Price. And so if the company surprises to the upside does Better than a consensus than the small cap stocks outperformed, the benefit of owning and etf and index fund is to be able to benefit from the upside surprises without having to identify which company will do Better and jump in Price by buying an asset class that is undervalue, there are potentially more embedded positive surprises that can be had generating outperformance.

One reason small cap stocks have struggled over the past year is water rates are higher. Small cap stocks by a large tend to have higher debt serving costs, particularly because the greater percentage of small companies have floating rate debt and higher leverage than larger companies. And so those higher debt serving cost have impacted earnings more for small cap than a large cap.

If we look at earnings over the past year for global stocks, they've increased three point three percent. This again as a data from asset and where is global, small cap stocks have seen earnings for eight percent in the U. S.

Large cap earnings have increased seven point four percent in the past year, where as U. S. Small cap has seen an earnings decline of nine and half percent despite the fact that small cap stocks earnings have fAllen over the past year.

If we look at the earnings s growth rate over the past five years, which includes the chAllenges over the past year, within that five year time span, global small cap stocks have had higher earnings growth. Five percent analyzed earnings grow through the past five years versus four, nine, eight percent for large company global stocks. However, if we look at U.

S. Small cap over the past five years, earnings have grown six point eight percent. They've lagged the U.

S. Large company stocks that i've seen earnings of seven point four percent. And so in the us, large companies stocks have had faster earnings growth over the past five years.

It's been partially driven by the magnificent seven tech stocks, including A, I and video that definitely contributed to large cap U. S. Stocks, earnings being very strong or earnings growing faster.

U. S. Small caps. So I put out the global stocks, large company stocks, of outperform global small company stocks over the past two decades. But if you look at a performance attribution of what drove the returns over the past decade, we've seen global stocks, as measured by the old country road inx eight point seven percent return, outperforming global small caps, which had six point eight percent.

This performance attribution is from asset camp dividends contributed about the same propose small cap and large cap, two percent annual divided contribution for small cap, two point three percent divided contribution for large cap earnings growth has been higher over the past decade for small cap stocks, seven point four percent annual contribution due to earnings growth versus five and a height percent earnings contribution for large cap stocks. So just based on those two factors dividing yields and earnings growth, small cap should have our performed large cap globally, but they didn't because small cap stocks got cheaper their Price to earning a show dell from twenty one point seven down to eighteen. That was about a two percentage points drag over the past decade per year, whether global large cap stocks got more expensive.

The p went from sixteen point eight to twenty one point one, and that added two point three percent year. And so large cap stocks benefit because investors are trying to pay more for them. Small cap stock were more neglected even though they had higher earnings growth over the past decade, and that valuation difference was enough to allow global large cap stocks to outperform global small cap stocks.

And that is so key to understand what drove performance is that the consensus of gotten more bullish regarding large company stocks are willing to pay more versus small cap. And that has been the case. David left, quit, who is head of U.

S. Equities for U, U, B, S, S. Chief investment office, said. If small cap earnings pick up, people will buy the stocks, the small cap stocks will surprise to the upside, and we could see small cap stocks start out performing large cap stocks.

If we look at forward earnings per share growth, this is based on bottom up analyst estimates from ibs. Over the next year, they're forecasting both globally and U. S.

That small cap stocks will have faster earnings growth. For global small cap, they're expecting sixteen percent earnings growth over the next year compared to ten percent for global large cap stocks within the U. S.

Small cap also expecting sixteen percent earnings growth over the next year versus eleven percent for large cap. So earnings expectations are there. If we go out and look at analysts expectations over the next three to five years, they're expecting a little higher earnings growth for large.

cap. But one of the things we've seen is they're ratcheting down the earnings growth expectations for large cap over the past three months while they are increasing the expectations for small cap. And one of the things that we looked at in analyzing stocks on asset camp as well as money for the rest of us plus is our earnings expectations increasing months a month are and is getting more bullish.

And they are for a small cap, less so for large cap. Financial times quoted joe Carry hall, who was us equity strategies for small mid cap with bank of america. Their analysis shows the only time that they've seen small cap stocks cell for a cheaper prize relative to large cap, and this could be U.

S. Small cap, was in one thousand nine hundred ninety nine, two thousand. And that was at the end of the internet bubble where the valuation for large cap dogs were super, super high.

And that started a decade where small cap dogs outperformed. Now U. S.

We've had a decade where U. S. Small cap stocks have lag.

If we look at valuation data for global small caps versus global large cap, this is from massive camp. This is based on forward Price to earnings ratio. So I I shared with you the expected earnings growth.

Now based on that, that earnings and dividing those earnings into the Price, we can get what's known as a forward Price to earnings ratio, small cap, just a little less expensive. The forward P E is sixteen point four versus seventeen point eight for large cap. And so from evaluation standpoint, despite what joe kerry hall said, I don't see a huge discount for small cap, which would include both growth and value relative to large cap.

I see a bigger valuation advantage is small cap value, which will get to in a minute and small cap excluding the U. S. Before we continue limit POS and share some words on this week sponsors, let's go back to this article by financial times.

Writing by Robin wiggles worth. He's with the F. T. Alphaville section of financial times.

He authored the article, small stocks, big problems and point IT out. Yes, outside the U. S, small cap has outperformed large cap, including in europe, U.

K, japan, emerging markets, but the U. S. Makes up most of the global small cap marketplace. So at the one point seven trillion dollars in smaller cap funds globally, one point three trillion dollars is invested in the us.

And so us is a big component, in his view, is, well, maybe something is different now maybe the fact that you small cap out performed over the long term historically, but given the U. S. Has seen small cap stocks lag over the last decade and two decades, maybe something thing is changed and things do change.

And he pointed out that back in the early twenty years century, really into the twenty thirties and nineteen nineties, that stocks had higher divided yields than the yield on bonds because stocks were considered more risky and they needed their compensation. Now that's reverse. Stocks have had lower dividend yields than bonds for decades.

So something changed wiggle worth is asking, has something changed with small cap to where they will not be able to outperform even though they have globally on outside s the U S. They have not we've already mention interest rates having an impact on small cap stocks, but that that's temporary less. We get an extended period a of higher rates for longer and that definite is possible that could have a disproportional impact on small cap stop.

But there seems to be something else. And wiggle worth quotes two studies that are linked to in the show notes of the episode, along with the financial times article. They point out in the studies that the quality of small cap stocks in the U.

S. Is declining, that because companies are staying private for longer as fined by venture capitalist, historically, most of the IPO s. Initial public offerings were small cap stocks, and we've discuss this in earlier episodes that many companies that do go public haven't figured out a business model that generates profits.

So they get added to the small cap in index and they're not profitable. Thirty percent of small cap stocks in U. S. Are not profitable.

What where does did is they looked at their favorite measure, quality, which is the gross profit of the companies divided by by their assets. In their paper, they show that over time, that percentage dropped as the quality of small cap stocks. The U.

S. Has worked, but the show that the quality of large cap stocks in the us has also gotten worse, not as bad as small cap, but there's also been a deteriorating quality of large company stocks. And again, IT appears to be a function of companies that are growing public, not being profitable.

So lower quality, and that is bringing down the overall index. What's fascinating is they find that this trend for declining quality doesn't hold outside the U. S.

In japan and europe. They've seen stable quality or even increasing quality for both large cap and small cap stocks, particularly in japan. Qualities improving.

That could be enough to explain why small cap in the U. S. Is under performing. The quality has gotten worse than IT has for large cap stocks. Now what do we do with that? Well, we perhaps need to be more selective in the type of small cap stocks that we hold.

We want to make sure that, that they're quality, that something that we've done in our motor portfolio, examples on money for the rest of us, plus we have an over way to small cap stocks in those portfolio. But we've done IT through etf that have some type of quality screen to them. They're dividin E, T S, where the dividends are growing.

And so because they're analyzing the quality of the dividends, whether the companies are growing their dividends, that suggests a quality company because we're generating enough profits to not only pay a dividend but increased the division. And this was an aspect that we talked about a few weeks ago and looking at division investing. And that's how we've implemented IT in our model ortons l examples.

And we've had those small cap allocations in place since june twenty twenty when we realized that we wanted to increase our allocation to stocks. And we did IT in equality way, focusing on small cap. Now they've not done as world's large cap, but the, for example, of the U.

S. Etf, foreign wisdom three etf to turn over eight percent analyzed over the past almost four years. The point is, is we're using a quality screen in terms of the etf, we used to invest in small cap and both of those E, T, S, because there they're divided focus.

They have a value orientation. Another reason small cap has tended out perform large cap over the long term, especially outside side the U. S, is they get a bigger performance contribution from either the value factor or the momentum factor or is just more Operative in the small cap space.

And that that's helpful week ago in our monthly webinar for asia campus subscribers, we showed a table where we sorted forty six stock index from around the world, covering ninety nine percent of the market, and we rank them from which area of the stock market is most attractively prize in terms of its valuation is furthest from its long term average, is cheaper, more attractive than its long term area age. And we used a measure of standard deviation in the number one position. The most attractive relative to its average is world X U S.

Small cap. And the second was world X U. S. Small cap value. And then we we went and we discussed what that means. This particular metric we were using is the specifically adJusting Price to earnings ratio. So it's looking at inflation adjusted earnings over the past decade and the world X, Y small cat value has A P E of fifteen point one versus a long term marriage of twenty two point nine.

Now that long term marriage was back to two thousand for world X S small cap, it's a little shorter, but the P E was eighteen and half as as a longer m average of twenty three point seven. So in the women are we talked about there's an area of the market if one is thinking about rebalancing and we show that the high valuations for U. S.

Growth compared to world X, U. S. Small cap. And one of the things that I did as an institutional investment advisors is that going to a client, and we recommend rebaLance to small cap from perhaps large cap and show if we could get a variation data. One of the chAllenges is as an institutional advisor that I found frustrating and have at times and money for the rest is not having the valuation data and the tools to make these type of decisions based on data.

Not I got feelings and Frankly, that's why were so excited about asset cap because I finally have the tools i've wanted for decades to actually analyze the stock market in the way, using building blocks, looking evaluations multiple ways, getting real time earnings data, both historical and forecasts and have IT right there as individuals. We can get that now and an incredibly accessible Price to one reason why we we're doing A W and r to share with you a recent update where we've added more tools or you can sort by metric, just like i've done in this episode. So if you'll go to ask a camped outcome, slash web or you can line up for that web in our scheduled for may third, even if you're not good channel, send you the video recording.

We need tools to be able to analyze the stock market so we can make basic decisions about where do we rebaLance to. And right now, despite the underperformance of small 8 stocks over the past five years and longer for the U。 S, their attractive, especially the value side of small cap outside of the U.

S. And their earnings expectations are double digits. And that combination could see over the next decade global small cap stocks and non U.

S. Small cap stocks double digit analyze returns. Now when will that start? We don't know, but that's why we diversify will make an allocation.

We don't put all our money in small cap, but I don't think small caps dead, especially outside of the us. The quality has not deteriorated that IT has in the us. And that doesn't mean U.

S. Small caps won't rebound either. But certainly outside of the U. S, where we have continued to see the long term out performance twenty years, ten years for global small cap stocks, I think they have a role in a portfolio.

And now you might consider an there that episode four seventy six. Thanks for listening. Everything i've shared with you in the subset band for a general education and not considered your specific risk situation, not provided investment office, this is simply general education on money investing in the economy. Have a great week.