The InvestMentor

April 23, 2003

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Someone investing in small cap stocks right now will probably rattle off one or more of the following justifications:

1) "Over time, they beat the broad market."

2) "Small caps are currently postured to beat large caps for the foreseeable future."

3) "Small caps provide diversification and should always have a spot in your equity roster."

My view? Rationale number one is B.S.. Number two is impossible to know, and not a sufficient reason to over-allocate to the asset class. And the best case for investing in small caps is the third rationale—one that I suspect is the least-often cited, since the first two hypotheses drive most investment purchase decisions.

The Small Cap Outperformance Myth

The idea of a small cap performance premium dates back a couple of decades to work done by Roger Ibbotson and Rex Sinquefield. It has lived on ever since thanks to a chart put out by Ibbotson and Associates, showing the historical growth of large caps, small caps, bonds, bills, and inflation over the last eighty years, showing small cap as king. But I, along with other braniacs who have given it much thought, have a few problems with that idea.

Any perceived sustained performance advantage of an asset class disappears once it's widely recognized. That's because capital flows to exploit the advantage, diluting it until it goes away. That's an axiom of the capital markets.

Speaking specifically to the study, there are three other factors to consider. First, if you look at the Ibbotson chart, there is no performance advantage to small caps for the first 50 years—it's all been since the '70s. Secondly, the data does not include transaction costs. The cost of trading small caps—spread and impact cost—is between two and ten times higher than that of large caps. Finally, the data on small caps suffers from "survivorship bias." Small companies that fail as business fall out of the data after they're de-listed. Which is to say nothing of what happens to small cap returns when adjusted for risk compared to large caps.

Any of these factors calls in the question the validity of a small cap premium. Most professional investors acknowledge as much these days.

Will Small Caps Beat Large Caps This Year?

There is a definitive cycle of when small caps beat large caps and vice versa. We know from studies that one size group beats the other from anywhere from a year to five years, followed by a change in leadership that goes on for about as long.

For most of the last three years, small cap has dominated large cap. To some, that's encouraging. To others, it's discouraging. I'm in between. A three-year cycle is about as long on average, but small cap could continue to lead. An even more pronounced cycle has dominated of late—that of the growth stock versus value stock. Growth stocks have led all year, and are early into their cycle outperformance phase. There hasn't been a size advantage for a while now.

In our portfolios, we've sought to take capitalize on a possible small cap growth performance advantage over the coming months. A recovering economy and market will be good for small cap growth because these "riskier" companies will be on a firmer economic foundation, and investor appetite for risk will increase and thus the attractiveness of small growth companies.

However, small cap value stocks could suffer because many are interest rate sensitive. Most of the small cap value universe is small banks and utilities. A recovering economy will bring with it increases in interest rates. If small growth leads the market, and small value lags, they will neutralize each other and small cap in aggregate will not stand out versus large cap.

The Real Case for Small Caps

The best reason to have small caps—growth and value—is because they bring diversification benefits. There are times when each asset class leads and lags, and no one really knows when those cycles start and stop. Over time, having a little exposure to each group smoothes your total equity return.

One can get this "style diversification" through deliberate stock selection from each of the subsectors of the market defined by size (large versus small) and valuation (growth versus value). But you can also invest in style-specific mutual funds or ETFs (exchange traded funds). We use all three, depending on account size.