There is a common perception among investors that over the long term, small cap stocks outperform large cap stocks. In exchange for more risk, you get more reward.
As it turns out, this is mostly untrue. The best small cap stocks offer more explosive upside potential, but as a group they don’t really outperform large cap stocks.
This article examines the long-term performance of large and small companies, and then provides two small cap stocks I think offer good opportunities.
Small Cap Stocks: Long-Term Performance
Wilshire Associates and FTSE Russell have great long-term data regarding the performance of large and small companies.
FTSE Russell Data
The Russell 3000 index tracks a very broad set of U.S. companies, representing most of the stock market capitalization in the United States. The Russell 1000 index tracks the large and mid-sized companies of that universe, while the Russell 2000 index tracks the small cap stocks of that universe.
Purely on a price basis, their small cap stock Russell 2000 index (red line) has outperformed the large cap stock Russell 1000 index (blue line) over the past four decades:
Chart Source: St. Louis Fed
However, with dividends reinvested along the way for both indices, the large cap stock Russell 1000 index is ahead after four decades:
Chart Source: St. Louis Fed
Large companies, especially dividend stocks, should not be underestimated. Over the past four decades, they have performed about as well as small cap stocks, and at the moment are ahead.
Wilshire Associates Data
With dividends reinvested, here is the four-decade performance from 1978 through 2018 for Wilshire’s various stock groupings based on Wilshire’s data:
Cumulative annualized returns since inception:
- Market-weight large caps: 11.4%
- Equal-weight large caps: 12.5%
- Market-weight mid caps: 12.7%
- Market-weight small caps: 12.3%
- Market-weight micro caps: 11.0%
Wilshire tracks the largest universe of U.S. companies, representing almost the entirety of the market. Their large cap stock index tracks the top 750 companies. Their small cap stock index tracks companies that are smaller than the top 750 but larger than the 2,500th largest company. Their micro cap stock index tracks companies smaller than the 2,500th company. There is no overlap.
Their mid-cap stock index is a bit different because it tracks the bottom 250 stocks of the large cap index and the top 250 stocks of the small cap index, resulting in a 500-company index of medium-sized businesses. It is 100% overlapping with other indices.
Most of the indices are weighted by market capitalization, but they have an equal weight version of their all-company index as well as their large cap index.
In Wilshire’s data, market-weight small cap stocks did outperform market-weight large cap stocks. However, the best-performing group was market-weight mid cap stocks.
Interestingly, equal-weight large cap stocks were the second best performing group, slightly ahead of small cap stocks. The top 750 companies by size, when held in a portfolio in equal amounts, outperformed small cap stocks when held in order of market cap.
This is confirmed by the fact that the equal-weight S&P 500 ETF (ticker: RSP) has outperformed its market-weight S&P 500 ETF counterpart (ticker: SPY) since RSP’s inception in 2003. Equal weighting works well over long periods of time for large high-quality companies.
Why Don’t Small Cap Stocks Outperform?
The best possible investing scenario is to identify a top small cap stock that will go on to become a large cap stock over the coming years, and go up in value by 10x or 100x.
Unfortunately, for every massive winner that does that, there are multiple losers. Both Russell and Wilshire data show that small cap stocks don’t really outperform as a group. They’re not bad, but over four decades they don’t really stand out either. Mid cap stocks are a potential sweet spot, that investors can benefit from either by directly investing mid cap fund or investing into an equal weight large cap fund which tends to have a lot of overlap with the mid cap space.
A 2017 study by Hendrik Bessembinder that analyzed all U.S. public stocks over the past 90 years found that small cap stocks have much higher performance variance. A smaller percentage of small cap stocks provide positive long-term returns compared to the percentage of large cap stocks that provide positive long-term returns:
As a consequence, small stocks more frequently deliver returns that fail to match benchmarks. At the decade horizon, only 42.4% of stocks in the smallest decile have buy-and-hold returns that are positive and only 36.6% have buy-and-hold returns that exceed those of the one-month Treasury bill. In contrast, 81.3% of stocks in the largest decile have positive decade buy-and-hold returns and 70.5% outperform the one-month Treasury bill.
Multiple studies have shown data like this. While the absolute best small caps outperform the best large caps over a given period, small caps as a group also have much higher rates of catastrophic loss. The average returns of large/mid caps and small caps are similar, but the median returns for small caps are lower.
For this reason, my preferred area has traditionally been mid cap and large cap stocks with high quality metrics, such as strong balance sheets and high returns on capital. Many investors think that they need to venture into higher risk areas to achieve outperformance, but that’s not really the case. Combining high quality stocks with weighting methods that maximize their potential (such as equal weighting or fixed weighting) is a serious strategy for very high risk-adjusted returns and likely for high absolute returns as well.
With that being said, if you can find an individual small cap stock that you have a deep understanding of and has a lot of good traits that are not currently priced in, taking a small position to potentially let it run can be a good bet. If it doesn’t do well, your loss to your portfolio is minimal, but if it does well, it could deliver 3-5x or more on its investment and give your portfolio a meaningful long-term boost.
2 Small Cap Stocks I Like
Written August 2019
Sierra Wireless (SWIR)
Sierra Wireless is a small Canadian company that has a global presence and focuses on technology.
Historically, their entire business has been about making modules, gateways, and routers so that various devices can connect wirelessly to the network. In other words, they are one of the oldest Internet of Things (IoT) companies, and have a considerable share of the market.
Let’s start with the bad news. Over the past decade, Sierra’s stock has taken a big long U-turn to nowhere:
Immense growth is expected from IoT within the next several years, but it has been a slower process than many analysts thought. And there have been a few hype bubbles along the way, like when Motley Fool began recommending the stock several years ago.
The company is currently not profitable in a GAAP sense. They don’t lose money, but they don’t really make money either. They have plenty of cash and zero debt, but have been unable to generate consistent and growing profits.
Now for the good news. As of late 2018, the company is under new management, and has significantly restructured and changed its priorities. Their core goal is to build their recurring software/service revenue, which should be much more profitable over time. In other words, rather than just sell the various hardware that lets devices connect to the cloud, Sierra has cloud and connectivity services that help companies deploy and manage those devices on a subscription basis, and wants to focus on expanding that to be a larger portion of their business.
As the CEO described in Sierra’s July 31 earnings call:
Secondly, we have more than doubled our recurring revenue pipeline from the beginning of 2019; and thirdly, we had strong subscriber growth in Q2, led by record activations of our Sierra’s smart SIM product. Our embedded smart SIM technologies in integral part of our overall strategy, we offer great benefits to our customers by simplifying SIM logistics.
Our embedded SIM connects in over 200 countries and it eliminates the need for multiple carrier SIMs and certifications. We also provide unparalleled end-to-end security by virtue of having the device and connectivity layer and Sierra Wireless is to complete end-to-end partner with proactive device and network management and monitoring.
Our Ready-to-Connect offering integrates all of these features into one solution. We’ve been working to build this out across our IoT Solutions product line. In Q2, we launched three new platforms with Ready-to-Connect capability.
Over the long term, the case for IoT is still strong. More devices will be connected to the cloud, including consumer products, cars, electrical grids, medical devices, agricultural systems, industrial assets, automation, and so forth. The question is, how fast? Here is American Tower Corporation’s estimate, citing data from Cisco, and Ericsson:
Chart Source: American Tower Investor Presentation
The key risk is that bigger competitors could outmaneuver Sierra and take their market share. The investing thesis is to see if Sierra indeed achieves growing recurring cloud/connectivity revenue over the next 3-5 years or not. For a stock with zero debt and plenty of cash, I’m willing to allocate a small position and see what happens.
Fortunately, back in June and again on the recent earnings call, the new CEO laid out a quantitative 3-5 target:
To be the leader in IoT Solutions that we are investing in people, our global MDNO footprint, tools, software training and operational processes. As I mentioned at our Investor Day in early June, our goal is to double our recurring revenue to $200 million within the next three years and then double it again to $400 million in the assuming two years.
Overall, we expect to drive consolidated revenue to more than $1 billion in three years time with approximate 60% of that revenue coming from our higher margin IoT Solution segment. This includes the $200 million of recurring revenue I mentioned. And at the IoT Solutions gross margins we’ll be north of 40%. As we build our pipeline and customer wins and IoT Solutions, we are focusing on consolidated revenue approximately $1.25 years from now of which 70% will be generated by the IoT Solutions revenue. Again, this will be inclusive of the $400 million recurring revenue that I mentioned.
If they don’t start to achieve strong growth in recurring revenue within their proposed timeline, this stock is probably one to sell. If they do, its price could multiply. The stock trades for less than 0.6x annual sales. If revenue increases, and the company becomes profitable, the price-to-sales ratio could increase to 1x or 2x, which could mean a doubling or tripling of the stock price with more growth potential after that. Let’s see.
Sandstorm Gold Royalties (SAND)
Gold mining has long been a difficult, cyclical, and relatively unprofitable business, but gold royalty and streaming companies have been some of the most profitable companies in the world.
Royalty companies finance gold exploration and production in exchange for getting a share of the production once the mine is developed. They are gold financiers, in other words, and many of them also have some exposure to silver, copper, oil, or other commodities.
Sandstorm is the fifth largest gold and royalty streaming company, with a market capitalization of a bit over $1 billion, and is still in the growth phase, meaning that the bulk of its royalties are in the exploration and development phase rather than the production phase.
Chart Source: Sandstorm Investor Presentation
Sandstorm grows in three potential ways. The core way is that as more of its development and exploration assets become production assets, its number of ounce-equivalents increases and it reinvests into more assets to grow exponentially. Secondly, if gold and silver rise in price, Sandstorm’s profitability increases, since their costs are relatively fixed. Third, Sandstorm trades at a lower valuation than its larger peers, so as it grows larger and more diversified, its stock is likely to earn a valuation premium.
The key risks, of course, are the opposite. If some of their largest development or exploration deals fall through due to politics or bad geology, Sandstorm’s growth would be impaired. The company has a huge development project in Turkey, for example, that a considerable portion of their near-term growth is expected to come from. Secondly, if the price of gold and silver fall, Sandstorm’s cash flow would decrease.
Chart Source: Sandstorm Investor Presentation
In the past, Sandstorm grew very quickly through share dilution because they started from scratch and had little initial capital to invest. It has not been a good investment for most of that time.
By 2018, enough of their early investments were producing cash flow, and Sandstorm became able to reinvest that cash flow into new royalty deals rather than finance those new deals with share dilution. Since then, the number of shares has been flat. That is when I bought my stake.
I intend to hold Sandstorm for at least several years throughout the rest of this business cycle. It is very uncorrelated with most other types of stocks, and I expect it to perform well from the later stages of an economic expansion. It could be volatile along the way, and a big pullback after its recent run wouldn’t surprise me, but I plan to dollar-cost average into it for quite some time as a small position.
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