Why Do Small-Caps Keep Getting Knocked Off the Game Board?

Art by Blaine Harvey

It wasn’t supposed to happen this way. Small-caps were slated to find their place in the sun. Instead, they shriveled. Their redemption surely will arrive someday, but that’s way off in the future.

Normally, small-cap stocks would outperform the rest of the field late in the bull market. Other than a handful of brief and temporary spurts, that didn’t happen in any sustained way during the last half of the 11-year bull run that ended in February. And now, with a wicked recession upon us, their hopes of topping the charts are dashed for the foreseeable future.

“Contrary to expectations, they’ve been laggards for some time,” said Dave Mazza, head of product at Direxion. That shouldn’t occur, according to the storied Fama-French study on the subject, which found that small-caps did better than large-caps over the long run.

Written in 1992 by Nobel laureate Eugene Fama and fellow scholar Kenneth French, both then professors at the University of Chicago Booth School of Business, the study reasoned that since small-capitalization stocks had more room to grow, they did best over time. Later updates confirmed that thesis.

A successful fledgling company can easily quadruple its revenue and earnings in a few years, whereas most large-caps are established and happy to grow by single digits. The promise of riding a small-cap to the stars is ever-alluring.

Keep in mind, once upon a time, today’s behemoths were small-caps. Microsoft went public in March 1986, and its market cap then was $777 million, or $1.8 billion in present-day dollars. And the software maker’s current valuation is $1.35 trillion, an exponential increase.

If the investing world were a board game, every player would have a chance to win. For small-cap shares since the 2008-09 Great Recession, however, an unusual number of perils have cropped up for this one woebegone player.

Chief among them are the growing predominance of large-cap tech companies since then. The overwhelming FAANGs (Facebook, Apple, Amazon, Netflix, and Google, parent Alphabet), along with Microsoft, have sucked the oxygen out for the small fry. Another small-cap obstacle: the slow pace of the last—and recently torpedoed—economic expansion, which was around 2% yearly. That didn’t create enough bounty to power small-caps into prominence.

Alas, the Russell 2000, the leading index for small-caps, has trailed for a while now. Not by a wide margin, as the economy’s rise benefited the entire equities market, yet enough to make a difference for investors. Since the market’s 2009 low, the Russell index rose 9.4% annually, while the large-cap S&P 500 advanced 11.2%

The Russell index has quite a range. Its smallest member has a market valuation of a little over $200 million and its largest is just under $10 billion. That pales before the mighty FAANGs—that group’s smallest member, Netflix, has a $193 billion value. (The collection’s largest component, Amazon, weighs in at $1.22 trillion.)

Actually, getting blown away by the FAANGs and other large-growth stocks is a relatively recent phenomenon. Often, small-caps do well coming out of a bear market, as the weakest of them have been culled out and a surge in recovery business benefits them more than the big boys.

That happened at the outset of the last cycle. From 2009 through 2013, the Russell 2000 outperformed the S&P 500 four out of the five years. Then, the gap began to widen. Last year, a great year for the market, the S&P 500 clocked a 31.5% return, and the Russell 2000 delivered 25.5%—not bad, yet with a six percentage point deficit, the small-cap benchmark embodies a lagging investment.

In the dark hour of a recession, of course, small-caps are at a disadvantage, lacking the resources of the big players. Even though stocks have climbed out partly from the late-February-early March crater, the difference between small and large is stark. Last week, the S&P 500 gained 3% and the Russell 2000 lost 1.4%. “That’s the risk you run,” said Larry Kochard, CIO of Makena Capital. “The strong get stronger, and the weak get weaker.”

Small-Cap Stumbling Blocks

That’s for sure. Large-caps’ leg up is remarkable. For instance, they have loaded on debt, thanks to low interest rates, and many of them have the wherewithal to service all this borrowing. The same can’t be said for smaller businesses, which investment bankers often send packing if they want to float a bond issue.

Small-caps’ woes also stem from:

Inherent Financial Weakness. The smaller stocks aren’t merely a mini-version of large-caps. Large-caps are simply sturdier. Especially since the recession thunderheads gathered, noted Nancy Prial, co-CEO of Essex Investment Management, “investors have chosen to shelter in larger, well-recognized brand name companies with perceived safety and thus shunned stocks that were under-followed, under-owned, underappreciated.”

Small-caps tend to have smaller customer bases, less extensive supply chains, and inferior access to capital, compared with their larger brethren. Those factors are formidable drawbacks when competing with the giants in good times and particularly in bad. Small-caps these days reek of risk.

Sector Imbalance. Part of the problem for small-caps is that tech isn’t a sizable presence in the Russell 2000, as it is in the S&P 500. Financials are more significant in the Russell index, though, and this sector is weighed down due to worries over defaulted loans in the recession. For the S&P 500, as of year-end, tech was 23.2% and financials 12.9%. For the Russell 2000, tech made up just 13.5% and financials had 17.6%.

Tech was a stellar performer in 2019; financials, with their vulnerability to low interest rates, not so much, even before the coronavirus-induced economic catastrophe. What’s worse, small-cap financials tend to be regional banks, which lack the firepower of major lenders such as Bank of America. For this year’s first quarter, analysts expect tech to gain 0.9% and financials to lose 14.9%. For the second period, tech is projected to be off 1.4% and financials down 20.9%.

Demographics. To Ryan Nauman, market strategist at Informa Financial Intelligence, the vast population of aging Baby Boomers, who are the nation’s primary investing class, is increasingly risk averse. And that’s not good news for small-caps, whose business failure rates always dwarf those of large-caps, and more so in a recession. “The global financial crisis left a bad taste in Baby Boomers’ mouths,” he said. Now retired or headed there soon, “they can’t afford another 50% loss,” which is what they got during the 2008-09 crash.

… But There’s a Plus Side

The enduring fact of investing is that it is cyclical. After the dot-com bust, tech stocks had a bad time. Thanks to the march of innovation, they are back with a vengeance. While the tech surge and other influences may have shredded the usual expectations for small-caps, the smaller companies do have a few things going for them that likely will emerge after the COVID-19 recession is finally over.

So, yes, making money in small-caps is possible, and surely will become even more possible once the current unpleasantness passes. For reasons such as:

Time Heals. Should we get a V-shaped recovery, Direxion’s Mazza said, people will load up on small-caps, as they will be cheap. Just the same, he doubts that kind of bounce back will take place. With the more likely U-shaped recovery, “it’s hard to see a stellar outperformance” for small-caps, he said. Still, the day will dawn when good news arrives. “Once earnings per share rises, and we see green shoots, small-caps will soar.”

Low Inflation, Low Interest Rates. Amid a whirlwind of federal spending, the typical fear is that unacceptably high inflation is on the way. But few believe that is really coming. Globalization, if in abeyance for the moment, automation, and other cost-cutting technology should keep inflation tame. In addition, the Federal Reserve and central banks worldwide are committed to low interest rates. Those conditions will make life easier for small-cap managements.

The M&A Imperative. The giants of corporate America have long history of mergers and acquisitions (M&As), as they seek to acquire promising smaller businesses to enhance their product offerings. Big Pharma has an insatiable appetite for biotech upstarts. The tech megaliths are the same. Alphabet is angling to buy wearables pioneer Fitbit for $2.1 billion. Facebook’s most famous buyout was of Instagram, the photo-sharing social network, in 2012 for $1 billion.

The truth is that smaller companies are simply better at innovating, and mergers and acquisitions are a smooth way for their founders to cash out of their brilliant business ideas. “The large-caps let the small-caps do all the work” of developing new products, observed Essex’s Prial. “Then they scoop them up.”

Niche Playing. Obviously, one need not confine small-cap investing to buying a mutual fund or exchange-traded fund (ETF) that tracks the Russell 2000 or an equivalent index. Plenty of gems are available for the discerning investor (although some may be a tad tarnished of late), one who likes individual stocks. Think if you had bought Microsoft stock in 1986.

To Matt Parker, a co-manager at Intrepid Endurance Investor, a small-cap mutual fund, owning stock in Skechers (market value: $3.9 billion), the sneakers company, is a wise investment. The fund first bought its shares in December 2018, according to Morningstar data, when the shares went for around $23 per share. Since then, the stock price almost doubled to $44 by year-end 2019, then took a dive amid the virus scare and now is priced at about $25, still above the fund’s original purchase price.

But given the shoes’ popularity and three decades of successful operations, not to mention a strong balance sheet, the stock should be headed upward once more, in time. “Skechers has been through cycles before,” Parker said.

And so, writ large, have small-caps.

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