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Small stocks, big problems

A truism of finance is that risk and returns are correlated. The stocks of smaller companies therefore do better than bigger ones in the long run. This is a foundation stone of both investment theory and practice.

Sure, they are more volatile and they can suffer long stretches of dismal performance — such as in the 1960s and late 1990s. But, over time, “small-capitalisation” stocks trump larger stocks in every single major market studied by academics over the decades. Across the world there are hundreds of billions of dollar invested purely on this basis.

And yet:

The Russell 2000 small-caps index has now lagged behind the S&P 500 large-capitalisation index since its inception at the end of 1978, overturning a century of return data across multiple countries.

These are admittedly price returns, since no total return indices go back this far. But including dividends wouldn’t change the picture. Larger companies tend to be more generous with their dividends, so it would probably only worsen the small-cap underperformance. And it looks even more stark if you start in 1984, when the Russell 2000 was actually born (with data going back to the late 70s).

It’s tempting to dismiss this as merely the result of the powerful momentum currently enjoyed by the 10 biggest US stocks, which are thumping even the S&P 490. And notably, this isn’t happening internationally, where small>big largely still holds true.

For example, here are the charts showing the small-cap indices of the UK, Europe, Japan and emerging markets versus their large-cap rivals (though admittedly over shorter periods, given limited data history in some cases).

But in the US, the small-caps effect seems to be . . . broken?

This matters more, given how the US has the biggest and most influential capital markets and accounts for the lion’s share of the small-caps industry. Of the almost $1.7tn invested in dedicated small and mid-cap funds globally, nearly $1.3tn of it is invested solely in the US, according to Morningstar.

The US also boasts the longest and richest data set underpinning the small-caps effect. If it can break there, it can break everywhere. So FT Alphaville thought it would try to find out what’s up with small caps.


‘Giant Payoffs from Midget Stocks’

That was the trumpeted headline in a June 1980 Fortune feature by the magazine’s senior editor Al Ehrbar. “Whatever the reasons for the small stocks’ superior results, the implication is obvious: buy little.”

The article was based on academic research by a little-known PhD student at the University of Chicago called Rolf Banz. Banz showed that between 1926 and 1975, the average annual rate of return from large US stocks was 8.8 per cent, while smaller ones averaged 11.6 per cent. Even when you adjusted for their different volatility, small-caps performed better than large-caps.

What Banz proved was the existence of a “size factor” in investment returns: you could pretty consistently harvest market-beating returns simply by buying smaller stocks.

At the time there wasn’t even a small-caps index — the Russell 2000 was born in 1984 — so this was a big deal. Subsequent research showed that this also held true in myriad international markets. A decade later, even Gene Fama, the father of the efficient markets hypothesis, grudgingly incorporated it into his models.

FTAV has previously written a chunky post on the history of “factor investing” so we won’t dwell too long on it here. But along with value, size can be considered an ür-factor — an effect so well-documented and widely accepted that even many people who think factors are mostly academic mumbo-jumbo consider it akin to finance industry scripture.

After all, it makes intuitive sense. Tomorrow’s big stocks are today’s small stocks. They’re often faster-growing, more nimble, more innovative, under-covered and under-appreciated, and therefore should perform better in the long run.

Even ür-factors can stink occasionally though. The post-2008 woes of value stocks were so wild they overshadowed the less dramatic underperformance of small caps. But value has now made a comeback, while smaller American stocks mostly continue to languish.

Why? And why is this pretty much only a US issue?

Magnificent small-cap headwinds

The recent dominance of the Magnificent Seven and other large stocks certainly helps explain much of the recent underperformance of US small caps.

Even inside the S&P 500 there is a stark performance disparity between the biggest stocks and the rest. The 10 largest now account for a third of the entire index’s market capitalisation, and one in four of every dollar earned by America’s 500 biggest companies, according to Goldman Sachs.

Julian Abdey, one of the portfolio managers of Capital Group’s $73bn SMALLCAP World Fund (the biggest small-caps investment vehicle globally) argues that this will inevitably pass.

Eventually this will burst and great smaller companies will emerge again. I just don’t know when . . . We’re still seeing lots of companies that we like.

At the same time, smaller companies are hurt relatively more by higher interest rates, both because of their greater relative debt burden — their aggregate net debt currently stands at more than three times earnings, compared with under two times for large companies, according to Furey Research Partners — and because of the composition of their indebtedness.

While larger US companies mostly borrow long term at fixed rates through the bond market, smaller companies carry more floating-rate debt, which has become much more costly over the past two years. They also have debt coming due over the next year, which will be more costly to refinance.

Bank of America estimates that if interest rates stay at their current level, it will translate into a 32 per cent hit to earnings over the next five years. Even if the Federal Reserve starts cutting rates as expected, it will still trim small-cap earnings by 24 per cent, according to BofA’s Jill Carey Hall.

However, the fact that US small caps have now underperformed the broader stock market since the 1980s — when research first showed that they over time outperformed — cannot be laid at the feet of Nvidia and Microsoft, or a single rate-hiking cycle.

So what is really going on? Well, it probably boils down to a combination of several issues, some technical, and some more fundamental.

Index shenanigans

Given the subject, FTAV had a chat with Savina Rizova, co-chief investment officer and head of research at Dimensional Fund Advisors, as no one embraced the implications of Banz’s early-80s research with more alacrity than DFA.

Not only was it founded by two other former Chicago PhD students — David Booth and Rex Sinquefield — it had already started a small-caps index fund based on the theory that smaller stocks helped investors diversify their exposures. Banz’s research indicated that small caps not only diversified but apparently enhanced returns as well.

Today, DFA manages about $677bn, and a decent chunk of that is invested in its suite of small-cap funds. such as its $15.4bn US Small Cap Portfolio. But this fund has done noticeably better than its Russell 2000 benchmark, despite being basically a passive fund.

That’s largely because the Russell 2000 is not actually synonymous with the size investment factor first identified by Banz. As Rizova points out, the dominant small-caps index has some quirks that help explain at least some of its long-term underperformance.

Unlike many other major indices, the Russell family is entirely formulaic, and the methodology is transparent. That means other investors can fairly confidently calculate exactly what will happen with the Russell 1000 (large caps), the Russell 2000 (small caps), the Russell 3000 (the entire market) and their various offspring on their big annual summer reshuffle.

However, the cost of this transparency and predictability is that hedge funds and trading firms will try to front-run weighting changes, demotions and promotions. Moreover, the massive surge of trading — the Russell reconstitution day is reliably the most hyperactive stock market day every year — means volatility and heightened transaction costs for small-cap funds that have to rebalance on the day.

According to Rizova, index peculiarities like this add up to 0.86 per cent average annual headwind for the Russell 2000’s performance across 1979-2023. Over time, that drag really adds up. As she told FTAV:

A meaningful part of the underperformance is this reconstitution effect . . . The rigid, index-driven trading is actually costing people a lot of the premium. Implementation really matters in this space.

In other words, a seemingly recondite, technical index construction issue explains a decent chunk of the Russell 2000’s long-term woes. But it doesn’t explain it all.

Nothing ever changes, until it does

One thing that sometimes gets forgotten on today’s science-obsessed Wall Street (though ironically rarely by actual former scientists who now work there) is that markets don’t obey iron laws of physics.

What might seem akin to financial gravity can sometimes flip, and never come back.

Take the relationship between equity dividends and bond yields. For more than a century, the dividend yield of the US stock market was virtually always greater than what you could get from high-grade bonds. Companies needed to entice investors to choose the riskiness of stocks over the respectable steadiness of bonds. Then, suddenly, in the late 1950s, the relationship reversed.

As the late financial historian Peter Bernstein later recounted to PBS:

This had never happened in history. It was a really unique experience. It wasn’t supposed to happen, because stocks are supposed to be riskier than bonds. I had two older partners. They were 15 years and more older, and they were veterans of the Depression and the one, my closest friend in the firm, always called me “Kid”. He said, “Don’t worry, Kid. This’ll reverse itself. This is unreal and not to be sustained. This will reverse itself.” Well, I’m still waiting. Stocks have yielded less than bonds ever since then.

. . . I never forget it, because it proved to me that when people say something can never happen and for 200 years it couldn’t, hadn’t been true, anything can happen. It was both very exhilarating, but also very humbling.

Perhaps the reason US small caps historically outperformed had little to do with financial theories about risks and rewards, or behavioural theories about investors wrongly favouring big names over obscure ones?

Perhaps it simply boiled down to smaller companies previously being better and faster-growing than their large-cap brethren? But now the relative quality of smaller US companies has for some reason atrophied, and stock market returns simply reflect that fact?

The Aim-ification of US small caps

The medium-term, top-level numbers are unfavourable, but not terrible. The five-year growth rate of the Russell 2000’s earnings per share has been 14.4 per cent, compared with the large-cap Russell 1000’s 15.23 per cent.

However, this understates a severe deterioration under the hood of the index. Almost a third of all Russell 2000 companies are now unprofitable, compared with about 5 per cent two decades ago, according to Goldman Sachs.

Why? It’s partly due to the shifting composition of the Russell 2000. Two decades ago healthcare stocks made up about 5 per cent of the benchmark, and most of them were stolid, reliable companies. Today, healthcare accounts for almost 16 per cent of the index, and most are high-risk, unprofitable biotech stocks.

But even when you exclude healthcare entirely, the average quality of US small caps has markedly deteriorated over the past two decades, according to research by Verdad Advisers.

Here is a Verdad chart showing its favoured measure of quality — the median ratio of gross profits to assets — broken down by sector but excluding healthcare.

Moreover, the average US small-cap balance sheet has deteriorated. If you exclude the tech bubble years, the long-term average net debt to earnings has been about 2 times. according to JPMorgan. Today, it’s more than 3 times. Given their greater sensitivity to economic growth, that makes small caps structurally more fragile than before.

It’s basically the slow Aim-ification of the once-vibrant US small caps universe. But again this begs the question: why?

Private equity, public market problems

Yes yes, it’s trendy and facile to blame private equity for absolutely everything, but hear us out.

Despite the big private equity funds of megashops such as Blackstone dominating headlines, leveraged buyouts are still mostly a small- and mid-cap phenomenon. That’s where private equity likes to play. And that gives small but fast-growing, ambitious companies an option that didn’t really exist when the small-cap concept was born in the 1980s. It’s today much easier to stay private for longer.

Column chart of Assets under management ($bn) showing We live in private equity times

Given the ballooning size of the private equity industry, it is plausible — even probable — that an entire swath of high-quality companies that would decades ago have been listed and members of the Russell 2000 now live inside a PE fund.

There they can remain until they are so large they qualify for the S&P 500, or are flipped to another PE fund or rival company. Meanwhile, mediocre companies might be offloaded to the public equity market sooner.

This is just a theory. But there is some data to back it up. Further research by Verdad indicates that more IPOs of weaker companies and frequent exits by stronger ones explain much of the membership churn and deteriorating quality of US small caps. Alphaville’s emphasis below:

At a high level, while there has been some decline in core profitability, most of the decrease in quality has come from an influx of unprofitable companies, which, after three years, enter the core cohort and contribute to deteriorating quality. In fact, the companies that have gone public since 2013, net of de-listings, currently account for 57% of our small-cap US universe of 2,750 stocks. Given the steep decline in quality since 2013 among new entrants, this significant influx has contributed to a broad deterioration of quality. To make matters worse, the exits from the small-cap universe have tended to be of higher quality than the core cohort.

Notably, US large caps have not experienced such a significant mix shift toward new, unprofitable companies, and the companies that have entered and exited have tended to be of comparable quality to the broader core cohort. There is also less churn in the large-cap segment: new large-cap companies since 2013, net of de-listings, only account for 15% of our large-cap US universe of 585 stocks.

Here comes the sun, and I say ‘it’s alright’

Smaller companies are often seen as a bit of a murky area, with less liquid securities and sparser analysis. Goldman Sachs notes that the median Russell 2000 stock is only covered by five analysts — and one in seven has only one analyst or no coverage whatsoever — compared with the 18 analysts who track the median S&P 500 stock. Microsoft has 66, according to Bloomberg data.

But, in reality, there is far more research and information on smaller US companies than ever before. That means they are not systematically trading at unfairly cheap prices, which would erode any systematic size premium they once boasted.

After all, when the small-caps effect was first discovered, quarterly earnings and annual reports mostly had to be ordered and sent by snail mail. Moreover, the average quality of reports is dramatically improved. The best, most detailed, financial statements of the US stock market in the 1980s would probably be worse than the worst ones being filed today. And they are instantaneously downloadable to anyone anywhere with an internet connection.

As an aside, if you’re interested, you can read the first-ever audited annual report by a listed American company here, from US Steel in 1903. Drawings and photos of its various smelters, mines, ships and trains made up about a third of its 65 terse pages. Phwoarr.

Some would probably argue that more information is not the same as better information . . . but c’mon. Whatever way you slice it, even ordinary investors today have access to more, better and faster information on a broader swath of the US stock market than even the mutual fund star manager of the 1980s could command.

Just to take one example, with only a few seconds of googling FTAV could find tons of information on Impinj — a small biotech Russell 2000 company with a market cap of just $3.3bn* — including every conceivable financial metric, short interest, insider sales, analyst estimates, market technicals, broader industry analysis, and even some classic r/WallStreetBets “due diligence”.

Sure, some of this just results in noise. But on the whole it is very likely that the kind of corporate gems that were overlooked and underinvested back in the 1980s are now widely known and analysable.

Lastly, while stock market liquidity drops off sharply under the S&P 500, even the smaller, sketchier corners of small caps are still far more tradable than before.

The main reason why the Russell 2000 is reconstituted annually rather than quarterly is precisely because small-cap trading costs used to be so high. Nowadays, that isn’t really a huge problem. For example, the bid-ask spread on Impinj is roughly half a buck. That’s obviously worse than the minuscule bid-ask spread on Apple or Microsoft, but better than the runt of the Russell 2000 would have had 10-20 years ago.

Impinj quotes
Microsoft quotes

As a result of these shifts — more transparency and better liquidity — at least some of the small-cap magic has probably permanently disappeared.

So what now?

Last November, Jeffrey Burton of Furey Research penned a deliberately provocative report titled “The Death of (Small Cap) Equities”, inspired by an infamous 1979 Businessweek cover story on The Death of Equities — which presaged one of the longest and strongest bull markets in history.

Despite being a small-cap specialist, Burton conceded that their quality had indeed suffered a “pernicious decline”, detailing the weakening in profits, revenues, balance sheet strength and returns on invested capital caused by what he called the “venture-isation” of the Russell 2000.

In the 1990s, small caps routinely delivered returns on invested capital in the teens and even as interest rates declined to 1% in the early 2000s, small company investors could expect low double digit returns from the index. Those days, like my 32-inch waste, are sadly long in the rear-view mirror. Today, the index ROIC is struggling to hang on in the 3-4% range.

But Burton says one of his main motivations was to see if he “could channel all the negative energy around small cap into a single essay and in so doing perhaps mark the sentiment bottom for the asset class”. In other words, by writing “the death of small-caps” he could help inspire a comeback.

And lo, there have subsequently been some signs of a recovery. Indeed, since the Furey report was published, the Russell 2000 has narrowly beaten the S&P 500.

Line chart of Cumulative price returns since November 7, 2023 (%) showing David versus Goliath 2.0

And there are plenty of analysts who think small caps are the place to be right now, mostly because valuations are modest relative to both recent and ancient history.

At a price-to-book ratio of just 2, the Russell 2000 is currently cheaper than the 10-year average of 2.2, and the 40-year average of 2.1, Goldman Sachs notes. In contrast, the S&P 500’s price-to-book ratio is close to the record 5 times it touched in 2021 and 2000 (the Nasdaq’s P/B ratio is close to 7.5 times). Given their greater sensitivity to economic growth, Goldman reckons US small caps will return about 15 per cent over the next 12 months.

However, just because something is cheap doesn’t mean it can’t stay cheap, or get even cheaper. And even if a cyclical bounce materialises, it obviously doesn’t mean all is well again in smallcapland. If this is fundamentally a quality problem, the quality of the Russell 2000 has to improve before its performance does.

* Sorry, fixed to reflect the fact that Impinj isn’t the smallest Russell 2000 company, and updated the market cap.

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