In theory, betting on the stocks of smaller, less well-known companies shouldn’t pay off. In practice, it’s doing spectacularly.
In the United States, the S&P SmallCap 600 Index has jumped 23 per cent over the past year. This basket of modestly sized, typically anonymous U.S. companies isn’t just a one-hit wonder, either.
Over the past decade, it has generated better returns than its far bigger, far more famous cousin, the S&P 500, which includes Facebook, Amazon and all the other heavy hitters of the corporate world.
A similar small-cap boom is taking place in many other parts of the world. In Japan, the iShares MSCI Japan Small-Cap ETF has returned 12 per cent over the past year and doubled the results of its large-cap counterpart over the past decade. Similarly, the iShares MSCI Europe Small-Cap ETF has made its investors richer by nearly 13 per cent over the past year and far surpassed its big-company equivalent since 2008.
What makes this small-cap dominance even more remarkable is that it comes at exactly the same time the deep thinkers of the financial world have concluded there is no particular reason to invest in small-capitalization stocks.
This, of course, is rather funny – at least to investing nerds. But the gap between theory and recent experience underlines the essential mystery around small caps. Sometimes these stocks boom. Sometimes they disappoint. Nobody has a great explanation for why - or for why the small-cap boom has failed to materialize in Canada.
Many commentators attribute the recent U.S. small-cap surge to the surging U.S. economy or Congress’s recent tax cuts or the effects of a stronger U.S. dollar. Maybe so, but that doesn’t explain why European and Japanese small caps are thriving.
Another popular rationale says small caps are outperforming because investors want to take shelter in businesses that can’t be disrupted by trade wars. The problem here is that small caps in the U.S., Europe and Japan also did better than their bigger counterparts between 2008 and 2013, long before anyone imagined an America First politician would occupy the White House.
In short, it’s not entirely clear why global small caps are performing so well. And the best authorities keep changing their minds on whether these stocks hold any special appeal.
Back in the 1970s, a number of researchers dug into the U.S. archives and turned up a fascinating fact: According to the best available records, small-cap stocks had produced much stronger results than big-cap stocks over the previous decades. The extra payoff for investing in smaller stocks was dubbed the small-cap premium or size effect.
It promptly became an article of faith on Wall Street. Managers launched scores of small-cap funds. Index providers developed small-cap versions of market benchmarks. Academics built the small-cap premium into their theories of how the market worked.
Just as promptly, the size effect disappeared. After the mid-1980s, small-cap stocks lagged behind their bigger cousins for more than 20 years.
As researchers began to dig deeper, the once-sacred size effect looked increasingly dubious. “Small-cap stocks have earned higher returns than large-cap stocks between 1928 and 2014, but the premium has been volatile over history, disappearing for decades and reappearing again,” Aswath Damodaran, a finance professor at New York University, concluded in 2015.
The most recent research isn’t willing to go even that far. “There never was a size effect,” writes Cliff Asness of AQR Capital Management in Greenwich, Connecticut. “The data used to discover it was flawed.” In a paper published last month, a group of AQR researchers found that adjusting historical numbers for delisted stocks and other factors erases the supposed premium for holding small-cap stocks in the U.S.
They point out, too, that the size effect disappears when you measure size in ways other than market capitalization. If you rank stocks according to their book value, or sales, or number of employees, smaller firms don’t produce stronger results. Equally damning, the size effect failed to show up in foreign stock markets, including Canada’s, between 1984 and 2017.
So it’s clear then: There is no extra benefit from investing in small caps. Definitely not. Except, that is, is if you look at the actual results over the past year or past decade.
This leaves investors in a quandary. Should they bet on a continuation of the current trend? Or pay attention to rigorous research that suggests it’s just a fluke?
One good idea comes from the AQR report. It notes that you’re unlikely to derive any consistent benefit from investing in small caps, but it says some strategies - notably value investing - appear to be work better among small caps than among larger stocks.
The smart thing, then, seems to be to invest in small-cap value stocks, rather than small caps in general. Both iShares and Vanguard offer small-cap value ETFs focused on the U.S. market. If you want to ride the current wave of enthusiasm for tinier stocks, they offer an intriguing way to do so.
WHAT IS A SMALL CAP STOCK?
A company’s market cap, or capitalization, is the market value of its stock. But what qualifies as a small-cap stock varies depending on which market you consider.
In Canada, the S&P/TSX SmallCap Index focuses on companies with between $100-million and $1.5-billion in market cap. In the U.S., the S&P SmallCap 600 Index includes companies with US$450-million to US$2.1-billion of market cap. In other global markets, index providers like MSCI Inc. use complicated calculations to break stocks into large cap, mid cap, small cap and micro cap segments.
Regardless of the methodology, small cap indexes span companies in many different sectors and include young, fast-growing businesses as well as stable, mature enterprises.
Ian McGugan