Small-company stocks, historically known for their potential to deliver outsized returns, have recently faced significant challenges, prompting investors to reconsider their strategies. Over the past decade, small-cap stocks, as represented by indices like the S&P Small Cap 600, have lagged behind their larger counterparts, with annual returns averaging 8.2% compared to nearly 13% for the S&P 500. This disparity has raised concerns about the efficacy of small caps as a growth engine in investment portfolios.
Current Challenges and Trends
The struggles of small-cap stocks extend beyond mere performance metrics. Today, a decreasing percentage of small-cap companies in indices like the Russell 2000 are profitable—now at around 60%, down from 70% before the COVID-19 pandemic and reaching levels not seen since the 2008-2009 financial crisis. This decline in profitability underscores broader economic challenges and structural issues within the small-cap sector.
Historically, despite representing a modest portion (5% to 10%) of investors’ U.S. equity holdings by market value, small-cap stocks have been prized for their potential to outperform. Academic research has identified the “size factor,” wherein small-cap stocks have historically outperformed large caps. Since 1927, small caps have delivered average annual returns of 11.7%, surpassing large caps by approximately 1.6 percentage points annually. This historical outperformance has been integral to modern asset pricing models used by sophisticated investors.
Factors Contributing to Underperformance
Several theories attempt to explain the recent underperformance of small-cap stocks. One hypothesis attributes it to prolonged near-zero interest rates, which may have artificially sustained financially weaker companies. Another suggests that regulatory burdens have deterred attractive, fast-growing firms from going public, opting instead to remain private where they may find more operational flexibility.
Strategies for Investors
Given the current landscape, investors seeking exposure to small-cap stocks may consider recalibrating their portfolios with strategies designed to mitigate risks and enhance potential returns:
- Focus on Profitability and Quality: One approach is to tilt portfolios towards smaller companies that demonstrate profitability. The S&P Small Cap Quality Index, for instance, has shown promising returns of 9.8% annually over the past decade, outperforming its generic counterpart by 1.6 percentage points per year. These indices typically favor companies with stable earnings and robust balance sheets, attributes that can help weather market downturns and economic uncertainties.
- Invest in Quality-focused ETFs: Exchange-traded funds (ETFs) that target quality stocks offer a convenient way to access small-cap quality. Examples include the iShares MSCI USA Quality Factor ETF and the Dimensional U.S. Small Cap ETF, which emphasize profitability and financial stability among their holdings.
- Consider Private Equity Opportunities: Another avenue, as suggested by investing writer Larry Swedroe, involves exploring private-equity funds that invest in attractive small-cap companies remaining private. While traditionally requiring accreditation (typically with a $200,000 salary or $1 million in assets), newer funds from managers like Pantheon and J.P. Morgan aim to address previous concerns such as high fees and lengthy lockup periods. These funds offer exposure to promising small-cap growth opportunities outside of public markets.
Conclusion
The challenges facing small-cap stocks underscore the importance of strategic portfolio management in today’s investment landscape. While historical data points to small caps’ potential for higher returns, recent trends necessitate a nuanced approach. By focusing on profitability, quality, and alternative investment vehicles like private equity, investors can navigate the complexities of the small-cap market while seeking to capture potential growth opportunities. Adapting to these strategies may help mitigate risks and position portfolios to capitalize on future market movements effectively.