The stock market has been very generous to investors since the recession of 2008. Over the past 15 years the S&P 500 large cap index rose 13.9% on average each year (source: Morningstar). The same, however, cannot be said for smaller company stocks. The Russell 2000, a popular small cap stock index, grew only 10.4% over the same period. That’s certainly not bad, but it is uncommon for small cap stocks to underperform large cap stocks for such a protracted period. Is it time for a turnaround?

Definitions first. Small capitalization stocks are shares of companies whose total market value – calculated by multiplying the total number of shares outstanding by the price of one share – is small relative to the overall U.S. stock market. The Russell 2000 small cap index includes the 2,000 smallest companies out of the 3,500 or so publicly-traded U.S. stocks. These are companies with a median market capitalization of about $1 billion. On the other hand, the S&P 600, another small cap index, is comprised of only 600 companies with a higher median market cap ($1.74 billion). There are other small cap indices with their own selection criteria.

Despite the discrepancies between indices, there are similarities. All these smaller companies’ stock prices tend to be less expensive relative to the shareholders’ equity on their balance sheets as compared to the prices of mid and large cap stocks. Furthermore, because small cap companies are smaller, their capacity to grow is greater. To grow by 10%, a company with $100 million in revenue needs “only” an additional $10 million in sales. A $1 billion company needs to generate $100 million more. Which sounds easier?

The small cap size premium was originally popularized by Gene Fama & Ken French in their 1992 paper “The Cross-Section of Expected Stock Returns.” Over the period from 1927-2023 small caps outperformed large caps by over 1.6% on average per year. That may not sound like much, but $1,000 invested in small caps in 1927 would have grown to $45.8 million by 2023, $34.5 million more than the growth in large caps. And although there have been times during those years when small cap stocks underperformed large cap stocks, the small cap underperformance since 2008 has been one of the longest anomalies.

Larry Swedroe, an author of over 18 books on investing, cites several papers by researchers concluding that the recent underperformance of the small cap asset class is due to an increasing percentage of so-called “junk” stocks – very small companies with low returns and poor liquidity. (See https://www.morningstar.com/alternative-investments/what-happened-size-premium).  The volatility and consequent returns could be improved by screening out such stocks through a focus on quality companies. That’s an argument for avoiding small cap index funds in favor of those that actively apply factors such as profitability and momentum.

Another paper referenced by Swedroe suggests that another likely cause of the more recent decline of the small cap premium can be traced to the greater merger & acquisition activity that has accelerated over the last decade or so. The number of higher-quality startup companies that have either been snapped up by larger companies without going public or that are remaining private for longer periods of time has increased to such an extent that the number of publicly-traded stocks in the U.S. has dropped by half over the past 20 years. Swedroe suggests that the better opportunities for higher small cap equity growth may be found in the private equity market.

No one knows whether small caps will outperform or not over the next decade. But more diversification in any portfolio is usually a good thing.

(Perigon Wealth Management, LLC (“Perigon”) is a registered investment advisor. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. The information provided is for informational purposes only and does not constitute investment advice nor should it be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. Past performance is not indicative of future results. All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed.)