Small Companies, Big Returns

December marked the end of the best quarter over the last 25 years for smaller, publicly traded companies’ stocks. The S&P SmallCap 600 Index advanced 8.3% for the month and a whopping 31.3% for the quarter. These gains are more impressive when compared against the S&P 500 (a measure of large–company performance). Coming into the fourth quarter, small–caps had lagged large–caps by an annualized 6.9% over the last five years. By the end of December, they closed the gap to less than 2.9% and showed strong momentum to potentially extend further.  In short, this quarter wiped out half the performance difference between large-cap and small-cap stocks. While one quarter does not make a trend, we believe that there are reasons to be optimistic about small–cap performance moving forward.  

The Theory and Reality of Investing in Small Companies 

For decades, investors and academics have argued that there is a premium earned by investing in small–cap stocks. Generally, small-cap stocks have weaker balance sheets, less liquidity, and less diversified business models. Researchers posit that these factors contribute to a higher risk profile, demanding higher expected returns over time. Demanding it, however, doesn’t make it so.  

Instead, we suggest that incremental returns result from investing earlier in a business’s life cycle.  Smaller firms may be more focused and nimbler. Moreover, they typically have less market share and thus more room for explosive growth. Many offer niche products and services that are in higher demand as the economy begins to accelerate.  They may also be among the hardest hit in a downturn as customers consolidate their spending with fewer vendors.  

Bifurcating equity markets into large versus small is a useful, but imperfect, first step toward identifying these earlier life cycle businesses. We acknowledge that there may be exceptions, however. For example, breaking up a large company into smaller ones does not necessarily instigate innovation or streamline a bureaucracy. Similarly, many large companies have successfully pursued “intrapreneurship” strategies by encouraging their teams to “think small” and extend the corporate life cycle by seeking new markets and opportunities. We believe that when investing in small-caps, finding businesses with this entrepreneurial spirit is more important than their size alone.

Source: Corporate Finance Institute (https://corporatefinanceinstitute.com/resources/knowledge/finance/business-life-cycle/)  

A Return to Outperformance 

Over the last 25 years, the S&P SmallCap 600 Index (+10.5%) has outperformed the S&P 500 Index (9.6%) by nearly 1%, annualized. The trend of outperformance has generally been persistent with two notable exceptions: the lead up to the dot.com bubble in the late 1990s and, more recently, the period since 2017. Small-caps also lagged modestly heading into the Great Financial Crisis in 2007. With hindsight, this pattern makes sense. Investing in innovation during periods with accelerating growth is more comfortable than during periods where growth rates are leveling off (or even reversing). Small caps have tended to shine when the economic environment turns upward. This quarter’s outperformance, therefore, should be taken as confirmation that the re-opening is happening and innovation and specialization will thrive. 

                                                                                                                                                     Source: S&P, Morningstar 

What’s Next 

As we look forward, rising confidence should embolden investors to revisit small-cap stocks. The transition into the post-COVID era, should push companies to growth mode from survival mode, favoring innovative solutions provided by smaller companies.  Additionally, investors may be more willing to accept the risk associated with investing in smaller companies as uncertainty around the economy lifts.  For those investors who are comfortable with active management, the more heterogeneous asset class can also be an excellent place for skilled managers to identify the individual companies best poised to benefit.  Given the performance of small versus large over the last five years, allocating to small caps may be uncomfortable. However, as PT Barnum once said, “Comfort is the enemy of progress.”