If you are young and have decades to invest, why leave hundreds of thousands to a few millions of dollars on the table? That's what will likely happen if you adapt a strategy that is well designed for managing risk and increasing income, but is not the most tried and true strategy for creating total return. In the accumulation phase the most important metric is total return. When you approach that retirement date the most important number on your portfolio spreadsheet will be the amount of money you have to go shopping for income. How much money do you have to spend? So invest in what delivers greater total return.
Small and midcap indices and stocks historically outperform large cap and dividend payers. Here's the long term history of that investing truth.
Now certainly only your great granddad has been investing from the 30s, so let's look at a more recent comparison. I did not do any exploration on the "best" small cap or midcap indices, I simply used iShares small (NYSEARCA:IJR) and midcap (NYSEARCA:IJH) indices as they have an inception date of May of 2000. That time horizon is over 13 years and a fair assessment of recent and "long term". Certainly a young investor might be in the accumulation phase for 30 years or more.
Here's the iShares small cap vs. the S&P 500 (NYSEARCA:SPY). The site low-risk-investing.com calculates total return with dividend reinvestment.
From May of 2000 IJR
Portfolio Total Return: 267.2%
The above portfolio's total return was 267.2%, outperforming the SPDR S&P 500 ETF's total return of 62.5%. The total return includes stock price appreciation and dividends.
Portfolio Volatility: 19.4%
The portfolio's volatility was 19.4% which was higher than the S&P 500 volatility of 15.6%.
So what happens when we use the midcap index? Here's iShares midcap ETF vs. the broader market.
From May of 2000
Portfolio Total Return: 215.4%
The above portfolio's total return was 215.4%, outperforming the SPDR S&P 500 ETF's total return of 62.5%. The total return includes stock price appreciation and dividends.
Portfolio Volatility: 18%
The portfolio's volatility was 18% which was higher than the S&P 500 volatility of 15.6%.
The risk return proposition holds true. The small caps carry more volatility and they deliver more by the way of returns vs. the midcaps as well.
So why do small caps outperform?
Here's what Warren Buffet had to say in an interview.
"If I was running $1 million today, or $10 million for that matter, I'd be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I've ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It's a huge structural advantage not to have a lot of money. I think I could make you 50 percent a year on $1 million. No, I know I could. I guarantee that.
The universe I can't play in has become more attractive than the universe I can play in. I have to look for elephants. It may be that the elephants are not as attractive as the mosquitoes. But that is the universe I must live in."
Mr. Buffet has to live there, but you don't, again if you're young and brave. It comes down to risk tolerance level. If you can handle the risk, you may be handsomely rewarded if market history repeats itself.
Small caps outperform because they are, well, small. They're more invisible. They're flying under the radar. They are not in the spotlight. They are not as scrutinized and valued. It may not be perfect, but the market is quite effective at pricing those large cap stocks that get all the attention. Many small cap companies fly under the radar. They carry more opportunity to be mispriced. Also, many investors will pay up for the more reliable large cap companies with storied histories of earnings and dividend growth.
Small caps typically will deliver more growth opportunity on the earnings side, and you won't have to pay up (as much). You can pay less for earnings and get more earnings growth.
Small caps tend to be thinly traded and that can present a huge opportunity. As the company grows its revenues and earnings and demand for the company increases, and a large number of investors seek that very limited supply of stock, that share price can take off in a hurry.
It is impossible to predict market direction in the short term, but many are suggesting that small caps are currently attractive to large caps in an environment where the big guys are fully valued or a little on the expensive side.
Many small cap companies are announcing double-digit sales increases. But sales growth for S&P 500 companies is only moving along at a low single digit pace, and the trend is going in the wrong direction.
Here's another advantage, with the U.S. economy growing, even at a modest pace, the small caps may hold an advantage in that 85% of their earnings are generated in the U.S. compared to estimates of 35-40% for large caps. If foreign profits are going to be impacted by a strong U.S. dollar, the small caps may hold favour in that regard.
A recent article also suggested that small cap earnings are projected to even outpace those of developing economies. Richard Bernstein was quoted mentioning that...
U.S. small cap stocks have projected earnings growth right now that is twice the projected earnings growth rate of overly touted emerging markets - 35% vs. 14%. I don't think people realize that.
I am not suggesting investors rush out and purchase small and midcaps because of the current conditions, but the above scenario and recent arguments for small caps demonstrate how there can be more long term value in the less followed companies that may have greater growth prospects. And when it comes to small caps we should certainly at a few zeros to the word "long" and write looooooooooong term.
Don't leave money on the table.
Large caps and dividends are getting a lot of press these days. And they can be wonderful investments that allow most investors to reach their long term goals. But there is clearly another path to greater total return; considerably more total return.
If an investor is in the accumulation phase the dividends and current income of the portfolio are essentially meaningless. The only use of the income is to drive the total return of the portfolio. To manage the income of the portfolio is a misdirection of your efforts and energy. Your energy will be put to greater use if you do everything with the goal of greater total return. In the end (retirement date for instance) the only thing that will matter is how much money you have to go shopping for income. Or perhaps you will then have such a great stash of funds that you may decide to hold a large cash position and a modest amount of income generating products such as dividend paying stocks and bonds. With more money in the bank, you will have more options. You will retire more comfortably; you may have excess funds to help family or charities.
And converting to a very generous income producing portfolio can be as easy as 1-2-3 ETFs as I demonstrated in this article here, The Ultimate Income Portfolio. I used three ETFs that delivered generous initial yield and the income grew by 30% over the last 6 years. It delivered generous yield and income protection against inflation.
It's a risk return proposition. There exists the potential for greater total return beyond the land of the large cap universe. It comes with greater volatility. Most investors cannot handle having the majority of their investable assets exposed to a broad based index such as the S&P 500 or even lower volatility dividend growers such as Vanguard's (NYSEARCA:VIG) - never mind being exposed to an asset class that is even more volatile.
Remember, the broader markets fell some 50% from top to bottom from 2007 through 2009. The small and midcaps fell a little harder.
Do everything possible to evaluate and understand your risk tolerance level, and then match your holdings to your risk tolerance. Just because you have the time horizon necessary to hold more volatile assets does not mean you should take on that risk.
There are many articles on Seeking Alpha on risk tolerance and asset allocation. I might have a few articles on that myself if you search the Cranky page.
Thanks for reading and be careful out there.
Best of the Season to ya ...
Disclosure: I am long DIA, SPY, VYM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Dale Roberts aka cranky is a Streetwise Coach at ING Direct Mutual Funds. The Streetwise Portfolios offer index-based complete portfolios to Canadians. Dale’s commentary does not constitute investment advice. The opinions and information should only be factored into an investor's overall opinion forming process.