SUMMARY
Equities in small companies historically have produced greater returns than those of big companies in the wake of recessions. But this outperformance has come at the cost of higher risks.
Good things can come in small packages. Think dainty jewelry, tiny-but-powerful digital devices or nouvelle cuisine. But the “small-is-beautiful” adage also has relevance when it comes to the stock market.
Over time, shares in smaller companies – aka “small cap” equities – have tended to deliver high returns as compared to those in large companies or “large caps.”
To illustrate, check out Figure 1. Going all the way back to 1926, US small cap equities have outperformed their larger counterparts. What’s more, the margin isn’t small.
Figure 1. US small caps and large caps long-term relative performance
Chart shows the historical cumulative excess performance of US small-cap versus US large-cap equities. Source: CGWI Investment Lab, Fama and French, using monthly data July 1926 to June 2023. Time series is Fama and French ‘3 Factor SMB’ Series. †See glossary for further details on the series. Returns are shown for illustrative purposes only and do not represent the performance of any specific investment. Returns do not include any expenses, fees or sales charges, which would lower performance. Past performance is no guarantee of future results. Real results may vary. Fama and French ‘3 Factor SMB’ Series: The series subtracts returns of large firms (with above median market capitalization) from the returns of small firms (with below median market capitalization). The series covers US firms listed on the NYSE, AMEX, and NASDAQ exchanges. Small firms are determined as companies having size below the median market capitalization for the group. Large firms are determined as companies having size above the median market capitalization for the group. Small-cap firms are then divided into three groups based on their book-to-market ratio, with the bottom 30% defined as “Small Growth”, the middle 40% defined as “Small Neutral” and the top 30% defined as “Small Value”. Large-cap firms are also divided into three valuation groups based on their book-to-market ratio, with the bottom 30% defined as “Large Growth”, the middle 40% defined as “Large Neutral” and the top 30% defined as “Large Value”. The SMB series is calculated by the authors as the difference in average returns across the three valuation groups for each size category of firm: 1/3*(Small Value + Small Neutral + Small Growth) minus 1/3*(Big Value + Big Neutral + Big Growth).
What are small caps? (And mid- caps and large caps?)
Before we delve into small caps’ record – and the reasons behind it – let’s nail down some definitions.
An equity’s size is measured in terms of the issuing company’s market capitalization: share price multiplied by the number of outstanding shares. So, a company with a current share price of $5 and 100 million shares outstanding would have a market capitalization of $500 million.
So, how to work out which companies are small- and large-cap? (And indeed, mid-cap!) The usual method is to judge each company compared to the rest of its home stock market. Equity index providers typically do this job for us. In the case of the US, S&P categorizes shares like this:
S&P 500 Index: the largest 500 US companies with a market cap above $14.5bn.
S&P MidCap 400: the next 400 companies by size, with a market cap between $5.2bn and $14.5bn.
S&P SmallCap 600: the next 600 companies by size, with a market cap between $850m and $5.2bn.
(Levels as of July 2023)
Over time, as a company changes size, it may shift from one size index to another.
For example, take a young company whose profits and share price are increasing rapidly. Having gone public, it could rise from the small cap index up through the mid cap index and eventually join the large caps.
Likewise, a company whose share price falls significantly could find itself reversing that journey.
Other companies can spend long periods in a single size index or move between two such indices from time to time according to their share price movements.
Why have smaller cap equities outperformed over time?
We already noted how smaller companies in the US have beaten large ones over the last hundred years or so.
This is also true elsewhere, even if we don’t have a century worth of data.
In Europe, for example, small-cap equities have done much better on average than large caps since 2001.
US Small Cap |
US Large Cap |
Europe Small Cap |
Europe Large Cap |
|
|---|---|---|---|---|
Ann. Return |
11.0% |
8.7% |
9.4% |
5.0% |
Ann. Volatility |
19.4% |
15.4% |
18.5% |
18.5% |
Sharpe Ratio |
0.48 |
0.46 |
0.42 |
0.24 |
Max Drawdown |
-52.2% |
-50.9% |
-62.2% |
-49.0% |
Source: Citi Private Bank Global Investment Lab, Bloomberg. Monthly data Dec 2000 to July 2023. The Sharpe ratio divides an asset’s excess returns by its volatility to assess risk-adjusted performance. Volatility is how much asset prices move over a given span of time. Here, it is calculated as the annualized volatility of monthly returns. US Small Cap is the S&P SmallCap 600 Gross Total Return USD Index: Stock market index that tracks the stocks of 600 companies with small market capitalization. It represents the stock market’s gross total return, including price and dividend performance. US Large Cap is the S&P 500 Gross Total Return USD Index: Stock market index that tracks the stocks of 500 large-cap U.S. companies. Europe Small Cap is the MSCI Europe Small Cap Gross Total Return EUR Index: The MSCI Europe Small Cap Index captures small-cap representation across the 15 Developed Markets (DM) countries in Europe. Europe Large Cap’ is the MSCI Europe Large Cap Gross Total Return USD Index converted into EUR: The MSCI Europe Large Cap Index captures large-cap representation across 15 Developed Markets (DM) countries in Europe. The index was converted into EUR using the standard methodology set by MSCI.
But why might small caps have performed this way?
In the stock market, there’s no such thing as a free lunch, of course, be it nouvelle cuisine or anything else.
Higher returns may represent compensation to investors for taking outsized risks.
Another look at Figure 2 shows that small caps’ outperformance has been served up with a side-order of additional risk.
One way to measure risk is to observe “maximum drawdown” – the largest peak-to-trough decline that an asset’s price experiences in a certain period.
Between 2001 and 2023, both US and European small caps suffered bigger maximum drawdowns than their larger counterparts.
In the case of Europe, the gulf was wider: a 62.2% peak-to-trough plunge versus a 49% decline for large caps.
In both geographies, small caps were also more volatile, as measured by their standard deviation.
There are a variety of reasons for this additional riskiness.
Smaller companies may have less tested business models; be less established in their industries; have a more concentrated offering and operate in a smaller geography; have less access to funding; have less liquid shares; and offer less transparency around their fundamentals.
There are other risk measures to consider and investors should obtain advice based on their own individual circumstances from their own tax, financial, legal, and other advisors about the risks and merits of any transaction before making an investment decision, and only make such decisions on the basis of their own objectives, experience, risk profile and resources.
When have small caps done better and worse?
As we’ve seen, small caps have performed better than large caps over the long term.
That said, the outperformance has not occurred consistently. Rather, it has come in bursts.
These periods have sometimes lasted a decade or even more, such as between 1999 and 2011 in the US.
The flipside of this is that small caps have also had prolonged periods of underperformance.
Between 1983 and 1999, for example, the general trend was for large-cap dominance, albeit with a decent surge for small caps in the early 1990s.
However, the relationship isn’t entirely random.
Figure 3. US small caps have flourished in the first years of bull markets
Source: Citi Private Bank Global Investment Lab using Bloomberg data December 1986 to August 2023. Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Index returns do not include any expenses, fees or sales charges, which would lower performance. For illustrative purposes only. Past performance is no guarantee of future results. Real results may vary. US Small Cap is the S&P SmallCap 600 Gross Total Return USD Index: Stock market index that tracks the stocks of 600 companies with small market capitalization. It represents the stock market’s gross total return, including price and dividend performance. US Large Cap is the S&P 500 Gross Total Return USD Index: Stock market index that tracks the stocks of 500 large-cap U.S. companies. Bull and bear markets are measured from troughs and peaks respectively forming after market drops and rallies of at least 20%.
Over time, there’s been a marked tendency for small caps to beat large caps coming out of recessions.
In the US, small-caps outperformed large-caps in the year after fourteen of the sixteen recessions since 1926.
In Europe, small-caps outperformed large-caps in the year after three of the four Euro area recessions since 2001.
In both cases, a faster recovery in corporate earnings appears to have been a driver.
Considering small-cap stocks in a diversified portfolio
Observing small caps’ long-term performance historically, some investors may wonder if mightn’t be better to build an entire equity allocation from small caps in pursuit of returns.
Others might be tempted to switch aggressively between large- and small-caps in an attempt to catch those bursts of performance over time that we noted.
However, we would not suggest adopting either of these approaches.
An entire long-term equity allocation from small caps would be risky and prone to sustained periods of underperformance – perhaps lasting years at a time.
Trying to shift an equity allocation from one to the other in the hope of mainly being in the stronger performing would be fraught with complications, being a form of market timing.
Instead, suitable investors should consider long-term portfolio exposure to both small caps and large caps.
That said, certain periods merit bulking up or trimming down small- and mid-cap holdings depending upon investors objectives.
Here’s what the CGW CIO David Bailin and his team think about the current outlook for such equities.
