All blog content is for information purposes. Any reference to indivisual stocks, indexes, or other securities as well as all graphs and tables are not recommendation but only referenced for illustration purposes.
- Over the long-term, since 1963, small stocks performed better than large stocks
- During the past 35 years, since the start of the great bull market in the early ‘80s, large stocks performed better than small stocks
- Don’t give up on small stocks in spite of the past 35 years!
There is a tremendous amount of industry and academic literature that points to the fact that small stocks have performed better than large over the long-term. The accompanying graph is a common representation of those long-term performance results.
Growth of $1
July 1963 - July 2018
Source: Patton research
This long-term performance is unquestionable. As the graph shows, a $1 invested in small stocks in July 1963 grew to $639, a compounded return of +12.4%, while that same $1 invested in large stocks only grew to $172 or +9.8% compounded annually. This great long-term success doesn’t tell the whole story!
What is a “Small Stock”?
Before we dig into some additional performance analysis of small and large stocks, let’s first define what is a small and large stock.
The size of a stock is determined by the total value of all its stock. In industry terms this is called “market capitalization” or “market cap” (total number of shares x price per share). For example, to buy every share of stock in Amazon.com would cost $900 billion. On the other hand, to buy every share of stock in the furniture company Ethan Allenwould cost about $600 million.
Number of Stocks by Size
Amazon is clearly a large stock while Ethan Allen is considered a small stock based upon the following common market cap groupings:
- Mega Cap: > $200 billion
- Large Cap: $10 - $200 billion
- Mid Cap: $2 - $10 billion
- Small Cap: $300 million - $2 billion
- Micro Cap: $50 - $300 million
- Nano Cap: < $50 million
Many large and mega cap companies are household names while there are likely 100’s of small cap stocks you’ve never heard of. It’s these small, and generally lesser known, stocks that have delivered very strong long-term performance that every investor needs to benefit from.
Investment Thesis for Small Stocks
There are several strong arguments for investing in small stocks and explanation as to why they perform better than large stocks including:
- Higher Risk: small stocks are simply riskier than large stocks. Small stock prices tend to be more volatile than large stocks, the price of the stock fluctuates more, and investors expect to, and generally do, get compensated for this higher risk with higher returns.
- Faster Growth: small companies can arguably grow faster than large companies suggesting that their stock prices could move higher faster. There are many things that can cause this to not be the case but it is a strong argument for owning small stocks.
- More Insider Ownership: there tends to be a higher percentage of the company stock owned by "insiders", such as management and company founders, than is the case for larger stocks. This would suggest that management will be more motivated to see the stock price go higher.
These are a handful of very good reasons to own small stocks but investors must recognize that this logical support for small stocks does not always translate into better stock performance.
An entirely different story the last 35 years!
Clearly since the 1960’s, small stocks have performed significantly better than large stocks. This holds true when looking back to the 1920’s as well. But what looks so good over those many decades does NOT look so good the past 35 years! This is the rest of the story for small stocks.
Seldom discussed in the literature is that from nearly the start of the great bull market of the ‘80s, investors have been relatively disappointed owning small stocks as compared to large. As illustrated in the accompanying graph, $1 invested in small stocks in August 1983 has grown to $17 today while the same $1 invested in large stocks has grown to $40!
Growth of $1
August 1983 - July 2018
Source: Patton research
This performance is unquestionable as well. During the 35 years, large stocks have compounded annually at 11.1% while small stocks have compounded at 8.4%. And not only have small stocks delivered a meaningfully lower return than large stocks over this time, small stocks have continued to have higher risk than large stocks. This is obviously the worst of both worlds for investors.
As is the case for any investment with great long-term performance, there will always be periods of disappointment but, it goes without saying, 35 years is a very long time to test the patience of investors.
Should you give up on small stocks?
NO!!! Small stocks still very much belong in every portfolio. Here’s why:
No “Lost Decade” for small stocks
The 10 years from December 1999 to December 2009 is widely been labeled the “Lost Decade” for U.S. stocks. But that’s not the case for all U.S. stocks. This period is called the Lost Decade because large stocks, when including BOTH price change AND dividends, lost -9% of their value. But during this same period, small stocks gained +41%!
It was a lost decade for large U.S. stocks but certainly not small stocks. Diversification in small stocks dramatically improved the returns of an investor's portfolio during this decade.
The “Lost Decade”
December 1999 - December 2009
Early stage of bull markets
Bull markets are certainly a great time to own stocks but it is often the first year of a bull market, or early stage bull markets, that is among the very best. This is true for both large and small stocks but, as the accompanying table shows, small stocks tend to do much better than large during these periods. For example, following the bear market of 2000 – 2002, small stocks surged +63.0% during the first year of the bull market that followed while large stocks gained +35.1% during the same time.
There are some good reasons why small stocks tend to rally fastest at the start of a new bull market. One is that investors tend to being willing to take more risks in bull markets and will naturally gravitate to smaller stocks initially. Sometimes also small stocks fall more than large stocks during the bear market so there is more room for a rebound as investors go looking for the best opportunities. Regardless of the reasons, the fact is that the performance has been consistent for small stocks at the start of all six of the major bull markets of the past 50+ years. This is the kind of rally investors cannot afford to miss out on!
The tide can shift
It’s been a long 35 years for investors expecting their small stocks to perform better than large. This tide can shift quickly though and could persist for years when it does. Some major proponents of small stocks are hopeful now that maybe this tide may have turned in January 2016 given small stocks are higher by +51% while large stocks are up only +45% during that time. This is a short window of time but does provide hope.
Whether or not the tide is shifting now or not, investors must stay diversified to capture the benefits that all of these investments have to offer without owning too much of any one to avoid undo risk.
What’s it all mean?
Stay diversified! We never know which investment in our portfolio is going to perform the best in the future…that’s one of the reasons we diversify.
Large Stocks: S&P 500
Small Stocks: CRSP1-5 for 6/30/1963 – 8/31/1987, Russell 2000 since 9/30/1987