Dueling Fools

Dueling Fools
July 14, 1999

The Biggie Smalls Duel
Small Caps Argument
by Warren Gump (tmfgump@aol.com)

I'm probably crazy for taking the bull side of small-cap stocks. All you need to do is look at the track record over the last 10 years and it would be quite obvious that anyone investing in small-cap companies is stupid. Below is the performance for the Standard & Poor's 500 Index, a broad-based collection of 500 large U.S. companies, as well as the Russell 2000 and the Standard & Poor's 600, two measures of small-cap stocks:

Compound Annual Returns

      S&P 500 Russell 2000 S&P 600
10 Yr  15.7%    10.6%       11.0%
 5 Yr  25.3%    13.7%       15.5%
 3 Yr  26.9%    11.2%       11.4%
 1 Yr  21.1%     1.4%       -3.1%

Note: Due to data limitations, reinvested dividends are not included. If they had been, the S&P 500 outperformance would have been even greater. All returns calculated as of 6/30/99.

As can clearly be seen in the data, the disparity among performance between the S&P 500 and the two small-cap indices has increased in recent years. While small-caps underperformed the S&P 500 by about 5 percentage points over the 10-year period, they were trounced by almost 15 percentage points over the past three years. Looking at the last year, the S&P 500 index whipped its smaller brethren by 20%-24%. Whack!

So, why would I even consider investing in small caps stocks? Part of it is related to the disclaimer so often seen in mutual fund ads: past performance cannot guarantee future performance. Just because a stock or fund has shown great stock price performance in the recent past does not mean that it will do well in the near future. Perhaps moving your money into the "hottest performers" isn't the smartest move one could make.

Do you remember the biotech stocks in the early 1990s when they were the "hot stocks" to own. The Fidelity Biotech fund, a decent proxy for the overall sector, was up 44% in 1990 compared to a -3% return for the S&P 500. In 1991, the situation favored biotechs even more dramatically with the biotech fund up 99% compared to a 30% return for the S&P 500. With such dizzying returns, everyone felt that an allocation to biotechs was prudent. In the subsequent three years, however, the S&P gained 20% while the biotech fund fell 26%. "Chasing," or investing into, what had recently been the best performer didn't turn out to be such a hot idea as is often the case. You need to look at future prospects relative to current expectations to figure out whether a stock is attractive or not.

That anecdote reminds me of the mean reversion theory, which suggests that various asset classes tend to have fairly constant returns over long periods of time, although intermediate-period returns are quite volatile. This theory doesn't provide any guidance as to what will happen over short time periods, such as the next one, three, or five years. Instead, it states that over longer time horizons, such as 25 or more years, returns for a particular asset class will tend to gravitate toward their mean over history. Almost every study I've seen supports this theory by showing a dramatic fall in standard deviations over longer time horizons.

Between 1926 and 1996, Ibbotson Associates reports that small company stocks returned a compound annual return of 12.6% compared to 10.7% for large companies. Given their higher historical long-term returns, it would seem intelligent to always have some exposure to small-cap stocks. If you buy into the mean reversion theory, acquiring a stake in an asset class after periods of underperformance would make even more sense based on the underlying assumption that the asset class should rebound at some point.

Theories and strategies aside, the most compelling reason to consider small-cap stocks boils down to common sense. When buying a stock, you are doing nothing more than acquiring a piece of paper that entitles you to a small sliver of a company's assets and future earnings stream. Your objective, assuming that you are planning on holding onto the stock for a significant period of time (i.e., investing, not trading), should be to buy a company that will provide the highest future earnings stream. Based on current market conditions, you would be crazy not to investigate small-cap issues.

Using First Call estimates, the S&P 500 is trading at about 28x this year's earnings estimate, compared to a 20x multiple for the S&P 600. That means that for every dollar you invest in an average S&P 500 company, you are getting about 3 1/2 cents of earnings, compared to 5 cents of earnings for every dollar you put into the average S&P 600 company. Of course, since most of a stock's value is based on future year performance, the level of these earnings in future years is critically important.

First Call doesn't provide any long-term growth estimates for the S&P 600, making a comparison to the 10% growth expected for the S&P 500 impossible. Taking a look at projections for the next two years, however, provides some insight. Earnings for the S&P 600 are expected to grow 16% this year and 28% next year. On the other hand, analysts foresee S&P 500 earnings growing 12% in 1999 followed by 9% growth next year. (First Call computes the estimates for these two indices using differing methodology, making it inappropriate to directly compare these growth rates; the numbers do, however, provide a general indication about which index is expected to produce more growth.)

As always, each investor needs to make his or her own choice. You can buy into the largest stocks that have had big price run-ups and trade at high earnings multiples with relatively low growth estimates. On the other hand, you can put your money into the basically ignored small-cap sector and pick up stocks that are trading at lower earnings multiples, yet provide greater growth prospects. You go ahead and take whichever one you prefer, but I'll take the latter proposition any day.

Next: Blue Chips Rebuttal