For the past 90 years, small caps have outperformed large caps. After all, elephants don’t dance. But over shorter periods small caps have often flagged, especially in economic downturns. In fact, it’s an individual company’s growth that matters most.
The distinction between small/mid capitalisation (cap) stocks and large cap stocks might seem technical, but it’s long been a topic of active debate in the world of investing. Definitions of a large company and a small one differ depending on the source. Generally speaking, large companies are said to have a stock market capitalisation of over $10 billion, compared with small companies’ $300 million to $2 billion. Mid cap companies fit in between with capitalisations of $2 billion to $10 billion.
History shows that large and small cap stocks’ offer investors very different investment prospects. Most notably, small caps have proved to outperform over very long periods. A dollar invested in US large caps in 1926 grew in value to USD 5,767 by the end of 2018 (Credit Suisse Global Investment Returns Yearbook 2018. Total returns, with dividends reinvested). But a dollar in small caps would have been worth almost seven times more at USD 38,842.
Yet small caps do not always outperform. They have flagged in periods when economic activity has been weak, such as the Great Depression, and did not catch up with large caps until the early 1940s. By 1974, US small caps were only marginally beating large caps. From 1975-1983 they raced ahead.
Whether you look at US stocks or those of another market such as Switzerland, this pattern of long-term outperformance punctuated by shorter periods of flagging performance has continued so far in this century.
Small cap stocks
It is said that elephants don’t gallop, and this explains why the best small caps can outperform large caps. A smaller entrepreneurial company with a capitalisation of, say, $300 million is more likely to double in value than a large company valued at $15 billion, especially if it is exposed to a high-growth theme, for instance biotech, electric cars or urbanisation.
It is equally true that come a recession, small cap stocks can be high risk. Just as their small size can help them to grow fast in the good times, so they can be vulnerable in economic downturns. Unlike larger companies, their businesses tend not to be as diversified across different sectors and countries. They may also have higher debt.
But smaller companies are not so widely researched as larger ones, leaving more scope for the skilled investor to discover overlooked growth stories. This is even more likely in Europe, following the European Union’s MiFID II regulation, which has resulted in stockbrokers cutting back their research coverage.
Large cap stocks
While small cap stocks have proved to outperform in the long run, often it is the shorter term that matters more. The recent past has been one of those times when large caps have beaten small caps. For instance, the CRSP US Large Cap Index has far outperformed its US Small Cap Index peer over the past five years. While large caps have an annualised return of 10.8% over the period (Center for Research in Security Prices. As of March 29, 2019), small caps have returned a smaller 7.9%.
Of course, the past five years have been a heyday for large caps. America’s largest companies include the tech giants that are disrupting and transforming the global economy – namely, Microsoft, Apple, Amazon, Alphabet and Facebook. These are the superstar growth companies at the forefront of a changing global economy. Other well-known large companies include Berkshire Hathaway, Johnson & Johnson, Exxon Mobil, JPMorgan Chaser and Visa.
Four points to consider
There are four points to think about when deciding to opt for investments in small or large cap stocks:
- Long-term performance
The data does not lie so it is logical for an investor with a long-term horizon of perhaps over 10 years to opt for smaller companies, although there can be no guarantee that they will outperform over even this length of time.
- Stock selection opportunities
If you want an actively managed investment, small cap stocks are not so heavily researched as large caps, so there may well be overlooked investment opportunities.
- Varying risk profiles
Broadly speaking, small cap stocks may prove more vulnerable during recessions than large caps.
- A fashion for large caps
For the past five years or so, large companies have been in fashion rather than small caps – but then fashions change.
Growth matters most
When the strengths of large and small cap stocks are compared, neither outweighs the other. While small appears to be beautiful over the long term – and has been over the past 90 years or so – many of us have shorter investment horizons. An investor might choose to invest in both, but to lean more to smaller caps at times of buoyant economic growth and retreat to large caps when storm clouds gather.
At the end of the day, it’s the growth that matters most for investment returns. And, solid long-term growth can be found in any business, large or small.
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