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.
Including reinvested dividends, large caps have outperformed small caps over the past forty years:
Large companies, especially dividend stocks, should not be underestimated.
Now, historically after a decade of outperformance as large caps have enjoyed recently, usually a reversal happens. So, I wouldn’t be surprised to see small caps do better in the 2020’s decade.
However, as a structural rule, small cap stocks don’t have compelling outperformance.
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.
The only small-cap strategy I like is small cap value, because the evidence is better there for them actually outperforming long-term. Small-cap blend and small-cap growth, not so much.
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
Capri Holdings is a small cap luxury products company that owns the Versace, Jimmy Choo, and Michael Kors brands. They have a global presence, including popularity in Mainland China which is an important luxury market.
The past two years have seen declining global GDP growth rates followed by a pandemic, but going forward, they seem to be in a good place. They’ve been rapidly building out their ecommerce capabilities, and analysts expect a rebound in earnings. The stock is trading for a little over 10x forward consensus earnings estimates.
Chart Source: F.A.S.T. Graphs
Texas Pacific Land Trust (TPL)
Texas Pacific Land Trust owns a big chunk of the oil-rich land in the Permian. They get royalties for letting companies drill on their land, use their water, and build infrastructure like pipelines or other assets.
As of this writing, their market cap remains below $5 billion, despite impressive growth.
Chart Source: F.A.S.T. Graphs
Unlike oil producers, TPL has very limited expenses. This means they have less operational leverage and higher profit margins. So, while many oil producers were absolutely crushed by low oil prices over the last year, TPL was merely “inconvenienced” as their incomes took a hit but they remained profitable.
As energy prices normalize, TPL earnings are expected to normalize as well. They still have vast stretches of undrilled land, and plenty of opportunity for growth ahead.
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