Small-Cap versus Large-Cap
No one investment style will be continuously in favor with the investing public. There will be times when small -cap stocks outperform large-cap stocks and when large-cap stocks outperform small-cap stocks. In general, investors should strive to make more correct decisions than incorrect decisions.
The way to achieve this objective is to utilize strategies that work more often than not. So where do you start? It is critical to have a thorough knowledge and understanding of the history of the stock market. More specifically, investors need to know the historical return and risk characteristics of investment strategies. We do not have a crystal ball, so historical data must be our guide to the future.
History shows that small-cap stocks have outperformed large-cap stocks over time. The amount of outperformance has depended upon on several factors, including, but not limited to time period, market capitalization, monetary policy, economic cycle, etc. I consider the outperformance figures a rough estimate of what to expect in the future. Smaller-cap indexes are relatively new and thus may not provide a long enough time frame in which to accurately assess the data. Researchers have generally used data from stock exchanges to make comparisons between small-cap and large-cap performance. The 2006 Ibbotson Yearbook with data provided by the Center for Research of Securities Prices shows that from 1925 through 2005, stocks in the two smallest deciles of capitalization returned 12.0% and 14.0% respectively while stocks in the largest two deciles returned a geometric average of 9.5% and 10.9% respectively.
Why do small cap stocks outperform large cap stocks? There are a few important reasons: First, the small-cap market is much less efficient than the large-cap market. Information is generally not well known and travels more slowly compared to the information about a large-cap company. Managers and analysts can add value through research by uncovering information that is not widely known. This is not necessarily insider information. It is simply information that would be helpful in determining whether a stock is a good investment. Portfolio managers and buy side analysts must do their own research because the majority of small companies are not widely followed by sell side analysts. Second, smaller companies often have higher earnings growth than larger companies. Large companies have already grown and often have fewer opportunities to engage in activities that will have a large positive impact on earnings. Third, smaller companies are generally more volatile than larger companies so investors require a higher risk premium.
Very few things in life are completely free. So investors need to understand that profitable small cap investing requires patience and generally a higher risk tolerance. Not all small companies execute their strategies quickly and many of them hit stumbling blocks along the way. All else equal, smaller companies have greater standard deviations of returns. Higher volatility could result in greater losses, especially over short periods of time.
However, the evidence is clear. Small-cap investments have outperformed large-cap investments over time. An investor's personal experience will depend largely on when he or she buys or sells an investment.