Dueling Fools

Dueling Fools
July 14, 1999

The Biggie Smalls Duel
Blue Chips Argument
Bill Barker (tmfmax@aol.com)

You know, you would think that there would be some solid accepted data out there that we could just refer to about the statistical performance of small caps compared to large caps, but there really isn't. Oh, sure, there's the data over the last 10 years that everyone can agree on. Over the last decade, large caps (as measured by the Standard & Poor's 500 Composite Index), have returned 18.77% per year; small caps (as measured by the Russell 2000) have returned significantly less, at 12.39% per year. You could look it up.

And the data over the last 1-, 3-, or 5-year periods shows the same thing, except with an ever greater advantage to large caps -- the differential over the last year has become particularly spectacular. However, any Fool knows that these time periods do not stand for too much. We need to look at the numbers over the long term, and so we need figures going way, way back, and that's where the confusion comes in.

For some time there was a certain degree of credence lent to a University of Chicago study that showed small cap outperformance (11.6% vs. 8.8% for large caps) from 1926 to 1979. No less an authority than Vanguard founder John Bogle has cited statistics declaring that between 1925 to 1997 small caps had the upper hand at a 12.7% annual return vs. 11.0% for large caps. However, as has been articulated by David Dreman in his Contrarian Investment Strategies: The Next Generation, the studies showing this small cap performance were methodologically flawed. They assumed away half the spread between bid and ask for small caps at a time when the spread averaged 45%. Between 1931 and 1935 small caps were so illiquid that 58% of them did not trade at all on any given day. The result of all this is that one can't take the small cap data at face value. As TMF Jeff wrote in the Harry Jones port recently, when examining the data, you're best off concluding that small caps and large caps have fought to a draw over the long term.

Okay, so if the data doesn't support choosing one market cap class over the other as far as long term results go, why bring it up at all? Well, the one thing the data is pretty clear about is when small caps as a group outperform large caps. Those time periods have been essentially the height of the Great Depression (1931- 1935), during W.W.II (1941-1945), and from 1973-1983. That is, small caps have outperformed large caps in bad economic times, and have been utterly smashed by large caps during good economic times. Take a look at the graph in this article from our mutual fund area: the last time that mutual funds as a group beat the S&P 500 was in 1990-1992 -- the last time there was a recession. (Because of fees and expenses, mutual funds as a group basically can't outperform the entire market. However more than half of mutual funds can (and will) beat the S&P -- a strictly large-cap index -- during any year that small-caps and mid-caps are the superior performance.)

Simply put, the data over the last 60 years is pretty clear: when you're in good economic times, large caps are going to outperform small caps -- and by a meaningful amount. If you think we're currently in bad economic times (is that what my fellow Fool Warren thinks?), or that a recession is right about to start, then now might be a good time to start buying up small caps. Actually, if you think that's the case, you probably think that it isn't a good time to be buying anything at all, but I'll let you be the judge of that.

Me -- I'm not going to worry about it, because it's pretty obvious that we're not in anything that can conceivably be called poor economic times. That being the case, the continued dominance of a market being led by large caps isn't unprecedented, it isn't interesting, and it isn't likely to reverse -- no matter what the talking heads on CNBC say. (I must confess that I too fell into the trap of making this tired argument in our 1999 Duel, before investigating the data a bit further.)

So when you're choosing small caps over large caps, you're buying into a pessimistic scenario of what will happen next to the economy. But, beyond that, there are several reasons why buying small caps instead of large caps is an extremely difficult game to play.

Small caps require a lot more work than large caps. Though buying a small-cap index fund might make just as much sense as a large-cap index fund over the long-term, if you're investing in individual stocks, you have to buy far more small-caps than large-caps to get the same type of stability within a portfolio.

In the world of stocks, it isn't true that the bigger they are the harder they fall. I could demonstrate through plenty of anecdotal evidence how hard small caps can fall on just the slightest bit of unexpected bad news, but I expect that most readers here are already intimately familiar with that fact. As has been amply shown, the Foolish Four method is a perfectly valid investment strategy that can be employed with only four stocks -- four large cap stocks. But there simply is no way that any kind of a rational portfolio can be maintained with four small cap stocks, or probably any fewer than about 20.

Suffice it to say that investing in small caps takes a much stronger stomach, much more vigilance, a much larger number of companies to follow, and much more work in the research stage than large caps. Since the reward for all that doesn't include higher returns over the long term (and won't in all probability include higher returns over the short term), I'm quite interested to see what Warren has to offer in response here.

Next: The Small Caps Bull Argument