How does small-cap performance compare to larger companies?

If you ask ten different people the above question, you will likely get ten different replies because there is no definitive answer. Only when you begin to dig below the surface, do the hurdles for small-caps emerge. So, is the stock market's long-term performance heavily weighted to larger companies?

 

Hope soon disappears

 

A recent study compared the Russell 2000 index against the S&P 500 to analyse the performance of large companies and their small-cap counterparts. Those supporting the small-cap theory were buoyed by the performance in July, with the Russell 2000 index outperforming the S&P 500 by approaching ten percentage points. However, in August, the S&P 500 made up almost half of the lost ground, and was within touching distance of an all-time high, while the Russell 2000 index remained 10% below its all-time high reached in November 2021.

 

This prompts the question of whether there is a preference for large-cap companies and if there are scenarios in which small-caps might outperform.

 

Relative strengths

 

An interesting comparison was carried out between the S&P 500 (weighted) and an equal-weighted version going back to 1970. The report found that the weighted version outperformed significantly, which was greatly impacted by a small number of larger companies. The research also found a 95% confidence level that relative strength amongst the weighted variation was more likely to continue (when it changed) over periods as short as one month up to five years.

 

Sceptics will point to this research being based on historical data. Still, we know that history tends to repeat itself, although not guaranteed, in many walks of life, including stock markets.

 

Winner takes all economy

 

Developed countries have often been accused of encouraging and even maintaining a "winner takes all" economy. Even if you put aside the weighted impact of larger companies on their index, let us look at the percentage of total income amongst the 100 most profitable US companies. In 1975, the US's 100 most profitable (traded) companies accounted for 48.5% of total income. While the power of the large corporates is obvious even at this level, by 2015, large companies in the US were even more dominant, accounting for 84.2% of total income.

 

It is not difficult to conclude that larger companies were attracting the lion's share of contracts and sales due to their size and influence. This places obvious pressure on those outside of the top 100, who, using the 2015 figures, were fighting over just 15.8% of total income.

 

Is there really a small cap effect?

 

We know that cherry-picking statistics is a method used by many people to "justify" a particular view or strategy. The so-called small-cap effect is a hotly debated topic, as smaller companies have had periods of strong performance during economic growth but struggled during the recession. We also know that small company share prices tend to be more volatile than their larger counterparts, although the dot-com boom at the turn of the century provided a direct contradiction to this assumption. So, is there really a small-cap effect?

 

An analysis of NYSE stocks between 1936 and 1975 suggested a small-cap effect. However, more recent analysis carried out before 1936 and after 1975 suggests that the pattern of outperformance is not as clearly defined, with some observers suggesting it simply doesn't hold up. It all comes down to stock selection, whether looking at larger or smaller companies, but perhaps more relevant for those with relatively low market capitalisation.

 

Summary

 

There is also one additional issue that needs to be considered: investor inflows. If we focus on tracker funds, those based upon large company indexes tend to receive the lion's share of investment inflows. This creates demand for the underlying shares, and because larger companies are more dominant, this can become something of a self-fulfilling prophecy.

 

Alternatively, many small-cap supporters suggest that it is easier to double sales for a company with a turnover of $1 million than to do likewise for a company turning over $1 billion. However, this idea fails to consider the significantly greater risk/reward ratio often associated with smaller companies. There is certainly a lot to think about!

 

It's important to seek guidance from your financial adviser before making any decisions, considering a range of factors such as diversification, attitude to risk, and long-term investment goals.

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