Will small-cap stocks beat the large-caps?

Historically, small stocks (or small-cap stocks) easily beat big stocks (or large-cap stocks). But almost all of the better gains of small stocks occurred in one unusual nine-year period. Big stocks should do better in 2016. (“Cap” refers to market capitalization which is the product of the number of shares outstanding times the current price per share.)

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 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?

But 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.

Small-cap stocks jumped over nine years

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 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.”

Why small-cap stocks took off

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 pulled down the returns of big stocks.

Also, Siegel says 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 stocks.

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 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.

Large-cap stocks are generally less risky

For one thing, big companies have often survived past cyclical downturns. For instance, in 3M’s 112-year history, it has survived economic setbacks, including the Great Depression of the 1930s. The next recession will be the first real test for some small companies. Especially those that listed their stocks after the financial crisis and recession of 2008-2009.

Another plus with big companies is that they often haven better access to financing. Moody’s Investors 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. In fact, 3M earns about two-thirds of its sales outside the U.S., which reduces its exposure to any one market. Also, 3M sells over 50,000 products, which cuts its dependence on any given product.

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.

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

 

The Investment Reporter, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846

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