By Tim Courtney, Chief Investment Officer

Over the last three years, economic and interest rate data has swung the market pendulum every which way. This is especially true for U.S. large caps, which had a tremendous 2021 and a terrible 2022 followed by huge returns again in 2023 and YTD 2024. While smaller stocks have also had positive returns since 2020, the movements have generally been much less volatile and forceful.¹

The definition of a small cap stock differs by market participants and index providers, but typically a stock is considered small cap if the market capitalization of the company is in the smallest 10% of the market.² This means that as markets become larger, the size of small cap companies has also become larger. A decade or two ago, a company that was $500 million in size would have been seen as a solid small cap company. Today, a $1 billion company would be considered on the smaller end of that space. Small caps today are generally seen as having market caps of $1 billion to $5-7 billion.

Even though small caps only make up 10% of total market value, they are by far the largest piece of the market in number. Due to their frontline position in the economy, small caps tend to be among the first to recover when conditions improve, but also face the initial brunt when the economy starts to wobble—like the market’s own canary in the coal mine.

With this in mind, small cap stocks have different market behavior than large cap and mega cap stocks. These companies tend to be in weaker financial positions, so the market discounts their prices and charges them more for access to capital. However, this higher cost of capital has tended to benefit small caps investors because the cost of a company’s capital is the investor’s expected return.

Over the last century, and over most 5 and 10 year periods, small caps have outperformed large-caps.³ This is even true within market segments. For example, within the large cap space, defined as the S&P 500, the smaller companies within that set have outperformed the larger companies within the set. You can see this when looking at indices like the S&P 500 Equal Weight, which has performed better than the S&P 500 Market-Cap Weight.⁴

Over the last 5 years, larger companies, and specifically the 10 largest companies, have far outperformed the rest of the market.³ But that is showing up in valuations now. Many of the largest companies are trading at valuations 50% above their long-term averages,⁵ while small caps are trading at close to a 20% discount to their long-term valuation averages. As we’ve noted before, price is the primary driver of future expected performance.

An important point about small caps is that the list of these companies aren’t stagnant. Some companies grow out of the small cap space, while others fall into it. Look at Apple; in the early 2000s, it was a mid cap facing tough times, and now it's the second largest company in the world.⁶ Additionally, some investors may be concerned about 'zombie companies'—firms that barely survive without meaningful growth—it's important to note that these make up a small portion of the market. Indexes like the S&P 600, which exclude such companies by imposing earnings requirements, can help mitigate these risks.

While small caps have underperformed large caps recently, it’s worth considering small caps given their lower valuations and the higher expected returns due to the higher cost of capital. If you have any questions or need further clarification, don't hesitate to reach out to your Exencial advisor.

Sources: 

1. The Wall Street Journal (6/12/24) – Small-Cap Stocks Are Having a Good Day
2. Investopedia 6/27/24) – What Are Small-Cap Stocks, and Are They a Good Investment?
3. MarketWatch (7/18/24) – 15 small stocks with big dividends that can grow even after the small-cap rally fades
4. TheStreet (11/2/23) – Market Cap Weighting vs. Equal Weighting: It Might Be Time To Shift Your Strategy
5. Investopedia (6/25/24) – S&P 500 Overvalued on Almost Every Metric
6. Business Insider (10/26/10) – The Greatest Comeback Story Of All Time: How Apple Went From Near Bankruptcy To Billions In 13 Years
    

PAST PERFORMANCE IS NOT AN INDICATION OF FUTURE RETURNS. Information and opinions provided herein reflect the views of the author as of the publication date of this article. Such views and opinions are subject to change at any point and without notice. Some of the information provided herein was obtained from third-party sources believed to be reliable but such information is not guaranteed to be accurate. In addition, the links provided within are for convenience only and the provision of the links does not imply any sponsorship, endorsement, or approval of any of the content. We do not guarantee the content or its accuracy and completeness. The content is being provided for informational purposes only, and nothing within is, or is intended to constitute, investment, tax, or legal advice or a recommendation to buy or sell any types of securities or investments. The author has not taken into account the investment objectives, financial situation, or particular needs of any individual investor. Any forward-looking statements or forecasts are based on assumptions only, and actual results are expected to vary from any such statements or forecasts. No reliance should be placed on any such statements or forecasts when making any investment decision. Any assumptions and projections displayed are estimates, hypothetical in nature, and meant to serve solely as a guideline. No investment decision should be made based solely on any information provided herein and the author is not responsible for the consequences of any decisions or actions taken as a result of information provided in this book. There is a risk of loss from an investment in securities, including the risk of total loss of principal, which an investor will need to be prepared to bear. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable or suitable for a particular investor’s financial situation or risk tolerance. Exencial Wealth Advisors, LLC (“EWA”) is an investment adviser registered with the Securities & Exchange Commission (SEC). However, such registration does not imply a certain level of skill or training and no inference to the contrary should be made. EWA may only transact business in those states in which it is registered, notice filed, or qualifies for an exemption or exclusion from registration or notice filing requirements. Complete information about our services and fees is contained in our Form ADV Part 2A (Disclosure Brochure), a copy of which can be obtained at www.adviserinfo.sec.gov or by calling us at 888-478-1971.  

S&P 500® Index (S&P 500®) is widely regarded as the best single gauge of large-cap U.S. equities. The index includes 500 leading companies and covers approximately 80% of available market capitalization. 

S&P 500® Equal Weight Index (EWI) is a version of the widely-used S&P 500®, where each of the 500 constituent companies is assigned an equal weight. Unlike the S&P 500®, which is weighted by market capitalization, the S&P 500® EWI allocates a fixed weight to each company - or 0.2% of the index total at each quarterly rebalance.

S&P SmallCap 600® Index (SP600) is a stock market index covering the small-cap segment of American stocks using a capitalization-weighted approach.