David stocks vs. Goliath stocks

Historically, small stocks easily beat big stocks. But almost all of the better gains of small stocks occurred in one unusual nine-year period. Big stocks should do better in 2020.

At first glance, it appears that small stocks do much better than big stocks. But look closer and both groups do about the same most of the time. That’s the finding of Jeremy Siegel, professor of Finance at The Wharton School of the University of Pennsylvania and author of Stocks for the Long Run.

From 1926 through 2006, small stocks (as measured by the Russell 2000 Index and its predecessors) delivered average yearly compound returns of 12.21 per cent. Over these 81 years, big stocks (measured by Standard & Poor’s 500 Stock Index) produced average yearly compound returns of 10.26 per cent.

Over long periods of time, even fairly small differences in percentage compound returns make a big difference. A thousand dollars invested in small stocks in 1926 would’ve grown to $11.25 million at the end of 2006. A thousand dollars put in big stocks over the period would’ve grown to only $2.736 million. What would you do with an extra $8.5 million?

Small stocks jumped over nine years

But to earn that extra $8.5 million, you would’ve had to hold small stocks from 1975 through 1983. Had you stayed out of stocks in the nine years from 1975 through 1983, you would’ve earned far less. Your small stocks would’ve generated average yearly compound returns of 9.61 per cent from 1926 through 1974 and 1984 through 2006. That’s basically the same as big stocks’ average yearly compound returns of 9.59 per cent over the same periods.

In fact, from 1926 through 1959, big stocks beat small stocks. Professor Siegel writes, “Even by the end of 1974, the average annual compound return on small stocks exceeded large stocks by only about 0.5 per cent per year, not nearly enough to compensate most investors for their extra risk and trading costs”.

The attraction of small stocks is that highly-successful small companies can turn even just modest investments into fortunes as the company grows. Such was the case with, say, Wal-Mart Stores. It grew from one store in a town in Arkansas into the world’s largest ‘bricks and mortar’ retailer. Also, a top-selling product has more impact on a small manufacturer than a big manufacturer. Even so, small companies are generally riskier than big companies.

For one thing, big companies have often survived past cyclical downturns. This is the case for US Key stock Starbucks Corp. The next recession will represent the first real test for some small companies. Especially those that listed their stocks after the financial crisis and recession of 2008 and 2009.

Another plus of big companies is that they often have better access to financing. The Value Line, for instance, gives Starbucks its top safety rating. Smaller riskier companies often find it harder to raise credit.

Big companies are usually more diversified. In fact, Starbucks’ owns 9,974 stores in the Americas and 5,860 elsewhere. It has also licensed 15,422 stores around the world.

Big companies often attract the best and brightest managers. Also, governments have shown that they’ll bail out companies that are ‘too big to fail’. Small firms, by contrast, must survive on their own.

In 2020, we expect big stocks to outperform small stocks. That’s because many investors have become fearful and will demand a higher degree of safety.

Remember the ‘nifty fifty’

Small stocks greatly outperformed big stocks from 1975 to 1983. Professor Jeremy Siegel says this partly reflects the collapse of the ‘nifty fifty’ big stocks in 1970s.

The nifty fifty included fast-growers like Polaroid, Sony, McDonald’s and Disney. The idea of buying proven companies makes sense. But even great stocks are a bad bet if you over-pay. In 1972, Polaroid traded at 90 times its earnings, Sony at 92 times, McDonald’s 83 times and Walt Disney 76 times. When the nifty fifty crashed, they reduced the returns of big stocks.

Also, professor Siegel writes that new laws in 1974 “made it far easier for pension funds to diversify into small stocks, boosting their holdings of these issues”. This demand, of course, assisted the run-up in the prices of small-company stocks.

This is an edited version of an article that was originally published for subscribers in the January 24, 2019, issue of The Investment Reporter. You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter.

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