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Large Cap or Small?

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When it comes to stocks, size matters. Since 1999, the small-cap Russell 2000 index returned nearly 60%, while its large-cap counterpart–the Russell 1000–has managed only a 14% gain. This is no one-time fluke: the little guys have beaten their larger rivals in every calendar year of the new millennium.

The graph below shows the return differential between small-cap stocks versus large-cap stocks. There is a clear tendency for leadership to run in trends, as the current six-year winning streak for small caps was preceded by a five-year run by their larger brethren. An obvious return advantage awaits those who can figure out which group is most likely to rule the roost.

The direction of interest rates is a common input in this decision-making process. Larger companies tend to go to the capital markets for their financing, usually fixed-rate securities. Smaller companies must use banks for the majority of their needs, and these loans usually contain a variable rate component. As a result, the earnings of smaller firms should be more sensitive to rate increases than large firms, making them inferior investments in rising-rate regimes.

To test this hypothesis, we ran a simple regression to determine just how stock price varies as rates rise. The results came out as expected, with smaller stocks definitively feeling the heat during rising-rate conditions, but the fits are not tight enough to be statistically significant. The current hawkish mood of the Fed clearly gives small caps the nod, but there are other factors to consider in picking one group of stocks over another.

Take valuations. Small-cap P/E ratios, currently around 19, are slightly higher than the 17.5 reading for large caps. Historically, small caps tend to trade at a slightly lower multiple than large caps, since the former is a riskier investment. In fact, small caps are about 50% more volatile than large caps, which explains why small stock indexes have, over the long-term, outperformed large stock indexes. Not wanting to overpay for a riskier bet, I tend to give this round to large caps as well.

Finally, one must consider current market conditions. Small caps do better when markets are surging. According to UBS, the average relative outperformance of small caps is highest when the S&P 500 index is up more than 10% in any given year. Considering the range bound nature of the markets, one is compelled once again to go with large-cap stocks.

With all these factors pointing toward larger stocks, you might think investors would have jumped on the large-cap bandwagon. But as of the end of August, the outperformance of large caps is barely noticeable. Advisors wishing to play the cap game on a conservative basis might want to start with a small tilt and increase it if large caps start running away with the ball.

The Puzzler, CIO of Memphis-based Sovereign Wealth Management, can be reached at [email protected].


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