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%
And in the five years since I ran that data large caps have outperformed small caps again, meaning the gap is even bigger now.
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
Valaris
Valaris (VAL) is an offshore drilling contractor. It’s worth under $5 billion, and yet it’s the largest offshore drilling company in the world due to how small that industry is. They operate a little over 50 drilling vessels that major oil companies can lease in order to perform their deep-water drilling.
The company filed for bankruptcy in 2020 and emerged from bankruptcy as a restructured entity in 2021. The whole industry was absolutely crushed in the years leading up to 2020. In the bankruptcy, equity investors were wiped out and bondholders became the new equity investors. As a result, the company now has a strong balance sheet with its debt wiped away, and has new management and investors.
The world faces tight oil supplies, and will likely have to increase offshore drilling. There are rather few drilling vessels in existence today, and even the capacity to make them at shipyards is limited. It would take years to add more drilling vessels to the fleet. The replacement value for Valaris’ drilling vessels is much higher than their current market capitalization, meaning that holding the stock represents the holding of these 50+ vessels at a small fraction of their replacement cost.
At first glance, the stock seems outrageously expensive with a price/earnings ratio of 100x. However, this commonly happens to cyclical stocks. If analysts are correct, their earnings will ramp up over the next two years, and the stock would be trading for a price/earnings ratio of 6x at current prices.
Will that happen? I don’t know. But what I do know is that the world is likely going to need more deep-water oil drilling, there aren’t many vessels to do it, the time to make more of those ships is several years, and Valaris is holding 50+ of those vessels at a small fraction of their replacement cost with a strong balance sheet and positive cash flows. I’m a long-term holder unless or until my thesis changes.
MicroStrategy
MicroStrategy (MSTR) is a business analytics and intelligence company founded in 1989 that has outlived many of its peers throughout the past three and a half decades. They’re perhaps most well known for holding bitcoin on their balance sheet, which has been their differentiated strategy since August 2020 when bitcoin was worth around $10,000.
They may seem bigger than a typical small-cap at first, with a market capitalization of over $9 billion. However, the vast majority of that value is from their bitcoin holdings. The actual business analytics business is worth somewhere in the ballpark of $1 billion, and then aside from that they have their huge bitcoin treasury.
And since adoption of that bitcoin treasury strategy, they have outperformed all major stock indices and even bitcoin itself.
Over time, a lot of the tech monopoly companies have eaten their smaller competition. It’s hard to survive as a small or medium-sized tech company for a long time. As a result, most business analytics companies have been acquired into larger entities or have gone out of business, with MicroStrategy being one of the sole survivors as a separate company.
MicroStrategy had structurally rising revenue until 2014. After that, their revenue started to diminish for a while, and then began stabilizing and going sideways. The company held very large cash reserves and no debt, but the market didn’t reward them for that fortress balance sheet, and their cash reserves underperformed other types of assets. In response to the pandemic/lockdown stimulus of 2020, where money supply grew massively, the company’s then-CEO and current executive chairman, Michael Saylor, worked with the board to pivot their reserves practices to avoid having their reserves be heavily debased. They decided to put their cash reserves into bitcoin instead, which has strong network effects and a finite supply.
Many companies return value to shareholders through dividends and share repurchases. That’s better than holding large amounts of debasing cash, and much better than doing non-strategic acquisitions. MicroStrategy also wants to avoid non-strategic acquisitions, but instead of decapitalizing their company, they put their retained earnings into bitcoin and build up a huge company treasury. They’re now tapped into a large and growing network effect, and thus have some bulwark to compete with the tech titans. As long as the Bitcoin network remains robust and its overall value and liquidity improve over time, MicroStrategy should have tailwinds behind it.
MicroStrategy will be the most controversial pick on this list by far. If you expect bitcoin to outperform the S&P 500 for the next 5-10 years (as it has over the past 5-10 years), then MicroStrategy will likely outperform as well. On the other hand, if you expect bitcoin to fail or stagnate, then MicroStrategy will run into similarly bad headwinds. Definitely do not purchase MicroStrategy if you are not long-term bullish on the price of bitcoin.
If you’re not sure either way, and want to learn more about the past, present, and future through the lens of technology, then my book Broken Money is a recommended read.
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