Following the recent election, small cap stocks (market caps below $2B) have rallied. Many pundits feel that a cycle of small-cap outperformance is just getting started. I personally have argued that stretched large cap valuations, the current Fed easing cycle, a strong domestic economy and the potential for decreased M&A scrutiny, provide the potential for small cap outperformance versus their larger counterparts. As with most financial ideas, there is significant nuance when it comes to investing in small caps.
When considering small cap stocks, it is important to know what you own. Many investors utilize iShares Russell 2000 ETF (IWM) to invest in small cap stocks, but this fund tracks an index with no profitability or return on assets screening. According to a Morningstar article, approximately 40% of the companies in IWM have negative earnings. Of these, many are zombie companies, which are managing to continue operation but will fail to meet their debt obligations over the long term due to high debt levels and low profitability. The iShares Core S&P Small-Cap ETF (IJR) and SPDR S&P 600 Small-Cap ETF (SLY) both track the S&P 600 Index, which utilizes a profitability screen to filter out unprofitable and zombie companies. The profitability screen utilized by IJR and SLY should lead to long-term outperformance versus IWM.
It is often cited that small caps have outperformed large caps over long time periods. If we consider the last 20 years, small caps (particularly IJR) led the way from 2005 through the onset of Covid. Since then, large caps have significantly outperformed, almost doubling the return of IWM (85% vs 44%). Adam Parker, CEO of Trivariate Research, has called small caps an inferior asset class based on their reliance on floating rate debt and increased economic sensitivity. It should also be considered that small caps lack the scale to support the huge technology spending that may be required to excel in the next 20 years. Has the landscape shifted to favor the largest companies?
The small cap universe can be fertile ground for active managers and investors that favor picking individual stocks. Typically, small caps have far fewer analysts covering them and much lower trading volumes. This can lead to mispricing which produces opportunities for those that can do their own research and generate their own fair value models. Additionally, small caps tend to lack the float necessary for institutions to take large positions because they would push the stock price around when adding to or reducing their positions. At the same time, there is significantly more business risk with smaller companies and their stock prices tend to be more volatile than large caps.
While it does seem to be a favorable backdrop for small caps over the short to medium term it is difficult to know how long that continues or how much favorable news has already been figured into their stock prices. While small caps always have a place in a diversified portfolio, going beyond a small tactical overweight is best left to active traders. When assisting clients with portfolio creation, I utilize low-cost ETFs and focus on asset allocations that limit correlation and seek to maximize returns based on an acceptable risk level. My hourly fee format is perfect for DIYers seeking professional advice without committing to AUM or subscription fees. If you are interested in learning more, please use this link to schedule an introductory call.