Small-Cap Stocks: Throw in the Towel or Ride the Rally?

Small Stocks, Small Returns?

Up until the recent market rally, the past several years had been extremely challenging for small- and mid-cap (SMID-cap) stocks. Prior to the election and vaccine news, and even including dividends, the Russell 2000 index of small companies had been flat since June 2018. In contrast, the S&P 500 had risen by 32% in that time, pandemic and all. In the past month, though, small caps have found their legs again, shooting up 20% and sparking a debate over how long this rotation can continue. Nonetheless, over the past decade, the S&P has still outperformed the Russell by close to 90 percentage points.

Especially if the pandemic has temporarily skewed cash flows in the economy toward larger companies, why have we maintained exposure to SMID-caps through all of this and why do we continue to own them as we look to the future?

 

To justify having any asset class in a portfolio, we evaluate three key metrics: expected beta, alpha, and correlation. Don’t be thrown off by the terminology. Expected beta is just the forecast market return of the asset class. As events unfold, you can measure that exposure with a benchmark like the Russell 2000 for SMID-caps. Alpha is the opportunity for active managers to add value by delivering returns over and above that benchmark. And correlation is simply the degree to which the asset class moves up or down with other asset classes and gives an idea of the diversification benefit it provides (the more positive the correlation, the lower the diversification).

The Puzzle of the Size Premium

For decades, it’s been thought that smaller companies offer value to investors along all three lines and most notably the first one, which investors called the “size premium.” This has been the subject of a lot of academic research over the years, most notably in the 1980s and 1990s. Even controlling for other factors, smaller companies historically outperformed larger companies over time. When asked why such outperformance persists, the conventional wisdom suggests that it’s because investors demand a higher return for holding small-cap stocks versus large-cap stocks, as they are likely to do worse in economic and market downturns. This is because small-cap companies tend to be less diversified than large-cap stocks (by business line, geography, etc.). This difference in risk, however, may not be large, as much of that can still be offset by holding a portfolio of many smaller companies and combining all of their various exposures.

Another explanation for the “size premium” is that small stocks tend to display faster earnings growth over time. This might be because the SMID-cap universe has greater opportunities to reinvest cash flows at high rates of return than the large-cap universe. Other explanations suggest that the SMID-cap universe has more opportunity for margin expansion, has more companies that can be acquired by their larger competitors or by private equity firms, and has more potential for activist investors to improve performance.

However, the SMID-cap universe does not always outperform the large-cap universe, or display faster earnings growth, or experience greater margin expansion. In recent years, the large-cap universe has outperformed the small-cap universe on these metrics, most noticeably as large digital economy companies have harnessed network effects to outgrow their peers while maintaining high returns on capital, thus allowing them to generate a large proportion of the overall market’s value and performance.

The question remains: Will the SMID-cap universe outperform large-cap stocks in the future? We expect that it will over time (perhaps only modestly), but we wouldn’t be surprised if this outperformance doesn’t show up for extended stretches, just like the past several years.

Alpha: The Key Reason to Own SMID-Caps

We see much more reason to own SMID-caps because of the potential to find stocks that can outperform the asset class return. We call this alpha, or the added value of active management.

The SMID-cap space is more fragmented than the large-cap space, has more dispersed fundamentals, and has more dispersed stock returns. In addition, the stocks tend to have less (and lower quality) coverage from Wall Street analysts. All of this presents more opportunity for research-driven investment managers to add value by identifying and owning the stocks poised to outperform.

Our analysis of our SMID-cap strategies suggests that they do in fact deliver that extra value over time. That is our primary reason for favoring ongoing SMID-cap exposure—in addition to delivering a market return close to that of large-cap stocks, SMID-cap alpha helps these stocks add to the risk-adjusted returns of our clients’ portfolios.

Optimizing Your Zigs and Zags

Finally, we consider the diversification element. This is less exciting than the magnitude of returns or the ability to add value over and above the market but is a critical component in shaping a portfolio’s asset allocation to meet investors’ long-term objectives. Again, for SMID-caps, there’s a case to be made in terms of diversification, but it is slight. SMID-cap stocks are highly correlated with large-cap stocks and have a marginally more negative correlation to Treasury bonds than large caps. So, while they do offer a diversification benefit to portfolios, it’s a rather mild benefit.

Know When to Hold ’Em

All of the above combines to support an ongoing strategic allocation to SMID-cap stocks. Our research team constantly evaluates and re-evaluates different asset classes and strategies to make sure that our portfolios have exposure to a mix of assets. But even more important than the breadth of that mix is that each asset class is there for a reason and should add value to the portfolio in combination with the other asset classes. While small caps have been a drag in recent years, we expect them to justify continued exposure in the future, allowing investors to achieve better results over time.