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Small caps lose lustre as investors embrace stability

Specialist trader Geoffrey Friedman (L) gives a price just after the opening bell on the floor of the New York Stock Exchange July 21, 2014.

BRENDAN MCDERMID/REUTERS

Small-cap investing has been in favour for the better part of the last 15 years. Now, there are some early signs that cycle is coming to an end, giving way to a new phase of large-cap dominance.

This year has seen a swift reversal of a long-standing preference for smaller stocks. Investors are now moving back into large caps that are cheap by comparison.

"There's a pretty big disparity in valuation between small cap and large cap," said Brian Belski, chief investment strategist at BMO Nesbitt Burns. "I think people became too fixated on small cap."

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As good as last year was for the S&P 500 index, which advanced by 30 per cent, the biggest U.S. stocks were handily outpaced by smaller-cap benchmarks.

The Russell 2000 index, which tracks small-capitalization U.S. stocks, gained 37 per cent, while the Russell Microcap index, which further narrows down the pool of stocks by size, increased by 44 per cent.

In fact, in all but two years since 1999, smaller stocks have bested their large-cap counterparts, making small-cap outperformance one of the dominant investing trends of the era.

This year is on course to flip that relationship, with market cap currently being one of the strongest determinants of stock performance. (Canada has not seen the same trends, given the dominance of resource stocks of all sizes.)

The Russell 2000 has declined by 1.6 per cent so far this year. The Microcap index has dropped by 4.1 per cent. Compare that to the 7-per-cent gain made by the S&P 500 year to date.

This has occurred despite small-cap companies continuing to generate strong sales and earnings growth. There are a couple of reasons for large-cap favouritism, and why the trend is likely to continue through the remainder of the year.

The first is that the long-held affinity for small caps has inflated valuations.

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The average trailing price-to-earnings ratio for S&P small-cap stocks is now about 1.4 times the P/E of the large-cap benchmark, which is at the high end of a range that has held for the last 40 years, said Pierre Lapointe, head of global strategy and research at Pavilion Global Capital Markets.

The second reason is timing.

From 2000 to 2008, small caps benefited from a period of credit expansion, Mr. Belski said. Credit is less of a concern for large caps, so when credit is growing, smaller companies can benefit disproportionately.

Then, postrecession, smaller U.S. stocks resumed posting outsized gains.

"It is normal for small caps to outperform the rest of the market just after a recession," Mr. Lapointe said in a recent research note. "Smaller stocks are considered riskier and often experience bigger pullbacks during the economic downturn. Once the recession is over, stocks that have been hammered the most usually rebound the most."

Now, five years into the recovery, with the U.S. Federal Reserve shifting toward a normalization of monetary policy, investors are embracing the stability and yield of bigger names.

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"You want to be in diversified brand-name companies, widow-and-orphan-type stocks," Mr. Belski said.

Of immediate concern to investors is whether the broader stock market can hold up if small caps continue to decline. Market pullbacks tend to be preceded by small-cap weakness.

But many other stock market and economic indicators are still headed in the right direction, Mr. Belski said. Cyclicals and transport stocks are still performing well, for example.

Plus, markets can sustain extended periods of small-cap underperformance without necessarily succumbing to a correction.

"We believe there's at least another two years of strong economic growth, which should bring strong stock market growth," Mr. Lapointe said. "But we wouldn't be surprised if this long secular small-cap outperformance is coming to an end."

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About the Author
Investing reporter

Tim Shufelt joined the Globe and Mail in August, 2013, primarily to cover investments for Report on Business. Prior to the Globe, he worked as a staff writer at Canadian Business magazine, a business reporter at the Financial Post, and covered city news and courts for the Ottawa Citizen. More

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