Time to Think Big

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.

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 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.

To earn that extra $8.5 million, you would’ve had to hold small stocks from 1975 through 1983.

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.

Had you stayed out of small 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 reurns of 9.59 per cent over this period.

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, now popular Wal-Mart Stores.

It grew from one store in a town in Arkansas into the world’s largest 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. For instance, in 3M’s 111-year history, it has survived economic setbacks, including the Great Depression of the 1930s.

The last recession was the first real test for some small companies. Especially those that listed their stocks after the recession of the early 1990s.

Another plus with big companies is that they often have better access to financing, Moody’s Investor Service, for instance, gives 3M its top credit rating. Small firms often find it hard to raise needed credit.

Big companies are usually more diversified. 3M, for example, operates in more than 65 countries worldwide. This reduces its exposure to any one market. Also, 3M sells over 50,000 products.

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 2014, I expect big stocks to beat small stocks. That’s because many investors have become fearful and will demand a higher degree of safety – despite the positive outcome of the January Barometer.

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 the 1970s.

The nifty fifty included fast-growing consumer goods stocks 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 pay too much. 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, Siegel says that new laws in 1974 I”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 stocks.

 

– Marc Johnson, CFA

 

The MoneyLetter, MPL Communications Inc.

133 Richmond St.W., Toronto, ON, M5H 3M8. 1-800-804-8846

 

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