Quant chart: Smaller caps, bigger potential?

Smaller caps have substantially underperformed their mega cap counterparts over the last decade. Remarkably, Apple alone is valued at over USD 3 trillion, exceeding the total market cap of the entire Russell 2000 Index.¹ A long-term perspective, however, suggests that smaller caps have big potential.

Figure 1 compares the performance of the MSCI World Equal Weighted Index with the standard MSCI World Index. The former treats each stock equally, while the latter gives more weight to larger companies. This highlights the performance of the average stock relative to the value-weighted market, which has increasingly been dominated by mega caps in recent years.

When the relative performance is blue, the equal-weighted index is outperforming; when red, the value-weighted index is outperforming. As you can see, historically speaking equal-weighting has generally outperformed value-weighting, supported by research indicating that benefits from size, value, and short-term reversal exposures outweigh the detractions from lower momentum exposure.² While equal-weighting typically delivers positive results, value-weighting significantly outperformed during the dot-com bubble (1994-1999) and from 2011 onwards.

Periods of underperformance for the equal-weighted portfolio often align with challenging times for active managers, who tend to deviate from value-weighted portfolios and are more tilted towards equal-weighted ones.

So, is this time different? When comparing the two periods of equal-weighted underperformance, we see remarkable parallels. Both periods are characterized by the rise of narratives around disruptive technologies fueling the emergence of new business models, leading to skyrocketing valuations in some market segments while investors neglect others.

Similar to today, equal-weighted portfolios fell out of favor at the end of the 1990s, just before a 10-year run of outperformance. This serves as a potent reminder that investors would do well not to fall prey to recency bias and overemphasize the recent outperformance of value-weighted indices. Historical, long-term evidence suggests that if (or rather, when) this trend reverses, a longer period often sets it, and equal-weighting outperforming value-weighting is more often normal than exceptional.

In this context, it’s worth taking a closer look at the relative performance of small caps versus large caps. While we are skeptical about size as a standalone factor, as their higher returns also come with higher risk,³ we observe that the MSCI World Small Cap Index outperformed the MSCI World Index over the last 20+ years (see Figure 2). However, similar to the analysis above, the large-cap index has been difficult to beat in recent years, particularly after 2018.

Is the recent underperformance of small caps due to weaker fundamentals or large caps becoming more expensive? Figure 2 illustrates that changes in relative valuations between these segments have significantly impacted their relative performance. Small caps tend to outperform when they become relatively more expensive than large caps, and underperform when they become cheaper.

Therefore, the underperformance of small caps over the last six years has been more a function of changes in relative valuation than of deteriorating fundamentals. In fact, annual valuation changes account for over 70% of the variation in relative performance. The widening gap between performance and valuation suggests that without this disparity, small-cap outperformance would have been much higher over the full period.

As of the end of June 2024, the value spread between small and large caps is at levels not seen in over 20 years (see the red dashed line), offering a multi-decade opportunity for investors. Specifically, small caps are trading at a discount of over 20% compared to large caps, based on a composite of valuation ratios (P/B, Fwd P/E, P/C, and 1/DY), while they have traded at a premium of up to 30% in the past.

This large and significant discount is consistent across different valuation ratios and cannot be attributed to differences in sector distributions between small and large caps. Since the valuation ratios also consider the (expected) profitability of different market segments, the argument that a decline in small-cap profitability might explain their underperformance is not supported.

The two graphical insights above highlight that investors should not overemphasize the recent outperformance of mega caps, as history and valuations show that this is more the exception than the rule. It’s worth considering a deviation from market cap weighting and having a more balanced exposure to both small and large caps in your portfolios to capture higher long-term returns.

Footnotes

¹ Apple market cap as of the end of June 2024. Cf., FTSE Russel, 2024 Russell US Indexes reconstitution: summary of preliminary changes, 2024.
² Cf. Swade, Nolte, Shackleton, Lohre, Why Do Equally Weighted Portfolios Beat Value-Weighted Ones?, Journal of Portfolio Management, 2023, 49 (5).
³ Cf., Blitz and Hanauer, Settling the Size Matter, Journal of Portfolio Management, 2021, 47 (2).