Are Small Caps Twice as Good as Large Caps?

 |  Includes: CIR, ESL, IWM, JNJ, SPY
by: Alan Brochstein, CFA

In Friday's drubbing, smaller stocks were absolutely hammered, falling 2.86% (for the Russell 2000) or approximately twice as much as the S&P 500's decline of 1.55%. Could this be a harbinger of a trend reversal? As you can see in the chart below (click to enlarge), the Small-Caps have absolutely exploded recently, rising twice as much since year end as the Large-Caps, with the R2000 up 15.01% compared to the 7.05% return for the S&P 500. Here is the past two years for the ETF for the Russell 2000 (NYSEARCA:IWM), with the relative price to the S&P 500 ETF, SPY:

A few observations:

  • Small-Caps have recovered to the highs of 2008, while clearly Large-Caps aren't there yet.
  • Small-Caps double-bottomed relative to Large-Caps after giving up big gains in 2008.
  • November 2009, though, was a great entry (I was days early with this call).
  • This chart looks like a potential "double-top" on relative performance.

I have been bullish on Small-Caps relative to larger companies for quite some time, especially as the economy was weakening in 2008, though I sure was caught off guard in late 2008 when they collapsed even more than Large-Caps. Before I share my rather simple rationale for my longer-term enthusiasm, consider a longer-term perspective of the relationship. This chart (click to enlarge) is slightly different, because I use the S&P 600 index (back to its inception) rather than the R2000:

A few observations about the past 15+ years:

  • The late 90s were the aberration - investors paid stupid prices for big companies.
  • The annual rate of outperformance has been 3%.
  • This most recent outperformance looks like a breakout from a consolidation of a longer-term trend.

As I mentioned, I have a favorable bias towards Small-Caps and expect that there is no correction relative to Large-Caps looming, though the torrid pace of outperformance should slow. The primary risks to my views would be a market crash that might (not definitely) lead to a flight to liquidity that would favor larger companies or a sharp correction in the dollar. Both of these are fairly low-risk events in my mind and they are also very common knee-jerk reactions that might not make sense, especially the dollar correlation. While it is true that larger companies generate larger proportions of their sales from overseas, the world has become much more global and small companies tend to increasingly look overseas as well or at least cater to companies that do export.

The reasons I like the prospects for smaller companies:

  • Stronger balance sheets
  • M&A prospects
  • Law of Large Numbers
  • Business Process Improvement
  • Valuation not a constraint

The current economic environment is particularly conducive to smaller companies outperforming. I have written about the relative balance sheet strength several times over the past few years, and this is perhaps the number one reason to favor smaller companies generally. They tend to have less debt and lots of cash. The average net debt to capital for the S&P 500 is 30%, while it is just 18% for the S&P 600. Maybe this wasn't always the case, but large companies generally bought back boat-loads of stock last decade or engaged in large M&A, funded with debt and intended to boost earnings in a flagging economy.

As we stand now, M&A is picking up again, but most of the activity is strategic in nature. I don't expect the bad behavior of the last decade in terms of extreme leverage to take place for several years. In an economy that will most likely continue to struggle to grow meaningfully, larger companies will most likely continue to look to these strategic acquisitions that we are seeing.

The "Law of Large Numbers" is nothing new but rather a reason to always like smaller companies (unless it is priced in). Quite simply, the bigger you are, the harder it is to grow. In a maturing economy, such as ours, this becomes even more the case.

One of the remarkable achievements of the last decade or perhaps two has been productivity improvements. Companies have been implementing better processes to minimize waste or improve quality. Well, these same processes are now trickling down to smaller companies, and I expect that the results will prove similar - better operating margins for a given level of revenue. If one wants to consider this point more carefully, I suggest that they learn more about Esterline (NYSE:ESL) or Circor (NYSE:CIR), for instance. They are just two successful examples that come to mind, but there are many more and will be many more.

My final point is that the relative valuations aren't a restraining factor. On a forward PE basis, the S&P 500 trades at 15.4X (average), while the S&P 600 trades at a much higher level (23X average) according to the analytics I use. At first glance, one might question my conclusion. Small-Cap coverage by analysts, though, has fallen off dramatically in recent years, with many companies having no estimates. I question many of the ones that actually do, as analysts seem to be lagging. When I look at Enterprise Value to EBITDA, which is backwards looking, they appear to be in line, both just under 9X. But these are just averages, which can be skewed by many factors. From my day-to-day analysis of individual stocks, I don't detect any sort of bias towards higher valuations of smaller stocks.

So, I continue to like the prospects of small companies relative to larger ones. With that said, I am cognizant of the recent run and have been shifting away in some cases towards some larger names. I won't say this universally, but there are many examples of mega-caps that seem unsustainably low in valuation. Barron's profiled one on the cover this weekend, Johnson and Johnson (NYSE:JNJ), that is a large position in my Top 20 Model Portfolio that I added in March. The model has performed exceptionally this year, and I have moved to lock in gains by several different tactics, including adding some larger names as I described last week. Despite my marginal adjustments, the model, which is measured against the S&P 500, remains quite extremely exposed to Small-Caps. In fact, 10 of the 20 names are less than $1 billion in market cap, while only 3 are greater than $10 billion.

To answer the question in the title, I expect that Small-Caps will continue to outpace Large-Caps as the year progresses, though not at the same pace as they have since late November, especially as the dollar likely depreciates somewhat. No trend continues indefinitely, but this one is supported by several different factors that don't appear likely to change for several years. Smaller companies are better able to navigate the difficult economic challenges that remain and are poised to grow faster on the top-line and to improve their bottom-lines more by adopting techniques that larger companies have already implemented. Small-Caps won't necessarily fare worse if the market is indeed pulling back unless we return to the panic state of late 2008 or early 2009. As I said earlier this year, 2010 is a year for chasing Alpha, and opportunities continue to abound in the Small-Cap part of the market. Happy fishing!

Disclosure: Long JNJ in a foundation I manage and both model portfolios