The intent of this article is to discuss the small-cap value premium.
This refers to the fact that small-cap value stocks tend to outperform the rest of the market over the long haul.
While we hope all of our articles are interesting, we think this may be particularly so for long-term, do-it-yourself (DIY) investors.
In this article, we’ll discuss (1) what classifies a stock as small-cap value, (2) how they’ve performed historically, and (3) why they may outperform in the upcoming decade.
What is a small-cap value stock?
A small-cap stock is a stock in a publicly-traded company with a
market cap of about 300M to 2B USD.
The market cap is the total value of all outstanding shares—the price of one share times the number of shares.
A value stock is one that has a low price relative to the company’s financial situation.
There is no precise definition of value, but metrics like
price-to-book (P/B) or
price-to-earnings (P/E) ratios typically play a large role.
Low ratios indicate cheap stock prices relative to company fundamentals.
Companies typically achieve value status when investors expect subpar growth in company earnings.
In other words, they pay more for non value stocks because they expect improvement in future earnings.
Of course, this may or may not pan out.
Value stocks have traditionally provided better investment returns, partially because earnings growth is so hard to predict.
How has small-cap value performed historically?
Paul Merriman constructed the table below using 90 years of data, from 1928 to 2017.
In short, it shows that small-cap value (SCV) achieved average annual returns superior to all other categories considered, including large-cap blend (LCB), large cap value (LCV) and small cap blend (SCB).
(Blend is a combination of value and growth stocks.)
There are other takeaways from this table.
Although SCV yielded the best average returns, it did so with higher volatility.
It had very good years with over 125% returns, very bad years below -55% and the highest standard deviation in investment returns.
In other words, investors without “strong hands” may not have been able to stay the course in SCV.
This is something important to keep in mind—high returns often require a strong stomach.
Another reminder from this table is the power of compound interest, and how seemingly minor things like fees can add up.
In the 90 years analyzed, 100 USD in SCV grew to over 8.6 million USD with 13.5% CRR.
The next best category (small cap blend) returned 12.2% and only grew 100 USD to 3 million—less than half as much.
So if you think expense ratios and advisor fees in the 0.5% to 1.5% range are negligible, think again!
Why do these stocks outperform?
Anytime you receive a tip about earning outsized investment returns, you should ask why.
If the investment really stands to outperform, why didn’t people already pile into it, drive up the current price, and hence diminish potential earnings going forward?
Is there some reason you are being informed of this investment before the majority?
For most investments, higher potential returns come with higher risk and/or volatility.
Consider the case of buying US treasury bonds versus stocks.
Throughout history, treasury bonds have been steady and reliable—the government has always made good on these debts.
Stocks, on the other hand, have sometimes failed.
Even stocks that have performed well have had periods of decline, where many investors had to either hold on or sell at a loss.
In exchange for this, stocks have had higher average returns over the long haul.
As discussed in the prior section, SCV stocks have historically had higher volatility than the rest of the stock market.
Hence, investors who may need access to their capital soon, or are risk intolerant, may not be well-suited for SCV investing.
The remaining (patient, risk-tolerant) investors should expect higher returns over the long haul in exchange for their advantages.
There are other factors that may help explain SCV outperformance.
For one, prices of small-cap stocks are less "efficient."
Smaller businesses are not analyzed as much, making it easier for stock prices to get higher or lower relative to fundamentals.
This is where the value metric comes in—it’s been easier for SC value to be under priced while SC growth gets overpriced.
Let’s talk briefly about why prices are less efficient, and why large institutions don’t take advantage of this (the reasons for these two overlap).
Institutions with huge sums of money can’t allocate a substantial amount of their portfolio to small cap stocks without bidding up the price excessively (negating the benefit of potential low prices).
Even smaller institutions/funds may not be able to access these investments as they are required to keep volatility below a threshold (remember SCV has been volatile).
This lack of "professional" interest in SCV means analysts don’t spend as much time researching them.
This further reduces price efficiency.
Will they continue to outperform?
No one knows the future of the SCV premium for certain.
However, there are good reasons to believe it will be positive over the next decade.
This is primarily due to current valuations.
While no category is cheap from a historical basis, most metrics show that SCV is priced much better than larger cap and growth stocks.
Cheaper prices typically lead to better future returns.
In recent interviews,
Bank of America’s head of securities Carey Hall provided the following facts.
- The 200 largest US companies are priced 22 times expected returns over the next 12 months. This is 42% above the past 35-year average.
- Mid-caps valuations are 30% above their long-term average.
- Small-cap valuations are 9% above their average.
So, while everything is expensive by this metric, small-caps are much less so.
Buying expensive stocks typically results in lower returns.
In the case of the S&P 500, check out the plot below from Bank of America.
As valuations rise (to the right in the plot), annual returns drop roughly linearly.
(A similar trend, but not as strong, exists for smaller cap stocks.)
At current S&P 500 valuations, this plot shows negative annual returns over the next decade!
Could we really see negative returns from the S&P 500 over the coming decade?
BofA analysts think so—they’ve forecast -1% returns over the next 10 years.
The last time they provided such a forecast was 1999.
So what did BofA say about small-cap value stocks?
Even though SCV did so well early in the year, it remains cheap relative to historical valuations in terms of price per unit earnings and price relative to book value.
Subramanian and Carey wrote that "valuations for the Russell 2000 suggest mid-to-high single digit annualized returns over the next decade,
and the relative forward P/E of large vs. small caps (0.78x, vs. the historical average of 1.03x) also suggests small should beat large over the next 10 years."
In addition to low valuations, small caps may get some tailwind from other factors.
The BofA report stated
"We also see other multi-year bullish themes for small caps,
including infrastructure/re-shoring, ESG improvement and the fact that we are less than two years into a new potential cycle for small vs.
large after underperformance from 2013-20 (cycles have usually lasted about a decade)."
Pros of small-cap value
- Long history of superior returns.
- Current valuations, though high, are much lower than other parts of the market (and other types of investments).
- Easy to invest in with modern ETFs like
AVUV, VIOV And AVDV.
Cons of small-cap value
- Long history of higher volatility, including extended periods of under performance. Investors typically need risk tolerance and a long time horizon to capitalize on these stocks.
- High performers grow out of SCV. The best small-caps grow to mid-cap and are therefore removed from SCV. (This sometimes works as an advantage.)
- Lack of diversification. There are risks (like COVID?) that hurt SCV in general, not just specific companies.
Hence, even an ETF highly diversified across SCV is not diverse enough for many investors.
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