In this episode of “Investment Management Foundations,” Gary Quinzel, Vice President of Portfolio Consulting at Wealth Enhancement, discusses the Small Cap premium, which is the difference in returns between Small Cap and Large Cap stocks.
VIDEO TRANSCRIPT BELOW
Hello everyone. My name is Gary Quinzel, Vice President of Portfolio Consulting at Wealth Enhancement. Thank you for joining this episode of “Investment Management Foundations.” Today's topic is a closer look at the Small Cap premium. The Small Cap premium is a term used in finance to help describe the difference in returns one can expect between investing in Small Cap stocks relative to Large Cap stocks, also known as the size effect. This was first documented back in the early 1980s by an academic named Rolf Banz. Then, it became increasingly more popular after the 1992 publication of Eugene Fama and Kenneth French's paper, “The Cross Section of Expected Stock Returns.” This came to be known as the Fama-French Three-Factor Model, which added both value and size to the capital asset pricing model, which helped set the standard for investment modeling for decades. The Fama-French Three-Factor Model, as mentioned, is an extension of that CAPM model, and it's just based on the idea that Small Cap and highly better valued companies tend to outperform the market over the long run. However, the size premium has been questioned in recent years due to underperformance relative to Large Cap stocks. Let's take a closer look at why the Small Cap premium may be waning and what might be some of the reasons.
If we look at a chart of the long-term history of Small Cap stocks relative to Large Cap stocks, we can definitely see that some persistent trends have existed over time. What we see here is the performance of the Russell 2000, which is a Small Cap index, relative to the S&P 500, which is a Large Cap index. When the line goes down, this indicates the large caps are outperforming. When the line goes up, this indicates that small caps are outperforming. What we can see are some notable trends: Notably from around 1993 to around 1999, we noticed that large caps outperformed, which coincided with the dotcom era, where large cap growth stocks led the market. It's understandable that small caps underperformed during this period. Then, we had a long sustained period from 1999 to around 2013, with several exceptions mixed in, where small caps generally outperformed. This is also a period where there was a sustained period of outperformance of value stocks relative to growth. Then, we saw from 2013 down to today where there's been a consistent trend where small caps have largely underperformed large cap. And again, for several recent years, we've observed that large cap growth stocks, especially recently dominated by the AI trend, have dominated the market and have led all returns.
But this isn't the only reason why small caps have underperformed, not just due to the outperformance of large cap growth stocks. There are several other factors as well. One of those factors might have to do with the quality of the Russell 2000, the small cap index. One way to look at the measure of the quality of the index is the percentage of companies that are non-profitable as part of the index. That number, the number of unprofitable companies back in the mid-90s, was around 15% of the index. That number has grown to almost 40% of the index today, which, in other words, a much larger percentage of the Russell 2000 Index is non profitable or of lower quality, and that might help explain one of the reasons why small cap stocks have underperformed.
Another reason is simply due to the fact that companies are staying private for much longer than they used to. If you look at the total number of listed stocks in the U.S., it peaked around 8,000 stocks in the mid-90s, and it's less than half of that as of 2023. What was observed is that more companies are either going private or staying private for longer, as opposed to doing their initial public offering (IPO). If we look at initial public offerings, looking at the data, the median age of a company when it did its IPO back in the ‘80s and ‘90s was around 8.1 years. In the 2000s up till today, that average is all the way up to 10.9, so companies are staying private for three years longer, and generally speaking, they're also much larger when they do their IPO. That trend has persisted through 2022; it's actually dropped the last couple years. But overall, companies are larger and older when they're doing their IPO. So, the way to think about this is the size premium may, in fact, still be there, but to access it, you have to tap into the private market, as opposed to capturing that in the public markets.
The takeaway from all this is that there's many ways to identify factors that help explain market returns over the long run, and by looking at the historical data. We can identify notable trends that can persist for a long time and can have no notable exceptions within those sustained periods. We can learn a lot about this in terms of how we invest, but this is just one factor, one point of analysis that we look at when we identify attractive investment opportunities, given the fact that inflation and interest rates are now falling or expected to fall further. That is one other quality that should be attracted to Small Cap companies, something that didn't persist for the last couple of years, that also might help explain some of the recent underperformance of Small Cap stocks. I hope you found today's episode of Investment Management Foundations interesting and useful, and please join us again for future episodes. Thank you and have a great day.
This information is not intended as a recommendation. The opinions are subject to change at any time and no forecasts can be guaranteed. Investment decisions should always be made based on an investor's specific circumstances. Investing involves risk, including possible loss of principal.
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