The Trouble With Small-Cap Growth Stocks

by: Gerstein Fisher

Summary

Historically, small-cap stocks have outperformed large caps, but small-cap growth has been a weak performer.

When we analyze small-cap growth stocks (US and international), we find that the asset class’ relatively poor returns can be explained by the ‘growthiest’ stocks in the category.

Investors can improve investment performance by stripping out the ‘growthiest’ of small-cap growth stocks.

In recent years, the relative performance of large-cap stocks, particularly in the growth space, has been so strong that many investors have forgotten that, historically, small caps have generated higher returns. From July 1926 to December 2017, small caps returned 11.9% annualized, compared to just 10% for large-cap stocks*. Presumably, at some point the pendulum will swing back to small companies, so we thought it was timely to update some research on the asset class we conducted nearly 10 years ago. In particular, we drilled down to study why small-cap growth has been the laggard among small caps, and whether there are strategies to enhance risk-adjusted returns for both US and international small-cap growth equities.

Exhibit 1 tells the story of small-cap growth’s relatively weak performance: it has lagged small-cap value by nearly 5 percentage points annualized—a very wide gap—compared to just 1.4 points for its large-cap growth counterpart. This makes intuitive sense in the context of the Fama-French three-factor model, which demonstrated that more than 90% of US equity returns could be explained by three systematic sources of risk—Market, Size, and Value. Small-cap growth, in effect, has lower exposure to the Value factor, and thus a lower expected return. But when we drilled down into the small-cap growth space, we discovered that the bulk of underperformance can be explained by the ‘growthiest’ of stocks within a growth index—which is also consistent with the Fama-French factor model.

Here’s how we dissected the asset class: We divided the Small Cap Growth Index (a proxy benchmark constructed by closely following the methodology of the Russell 2000 Growth Index) into five quintiles based on a measure of value. We divided the stock’s book value as of the most recent fiscal year end by its market capitalization. The greater the ratio, the greater the stock’s value exposure, with Quintile 1 representing the basket of securities with the highest value exposure and Quintile 5 having the highest growth exposure. In Exhibit 2, which depicts the growth of wealth of the five quintiles, the most value-oriented quintile, Q1, has the greatest growth of wealth and the portfolio with the highest growth exposure, Q5, by far the lowest.

Interestingly, not only do returns deteriorate as they move from the most- to least- value-oriented quintiles, but they also come with greater volatility (as measured by standard deviation). Exhibit 3 presents the annualized returns and standard deviations of the five quintiles. Note the steady deterioration of the Sharpe Ratio (a common measure of risk-adjusted return) during the progression to ‘growthiest’ small caps. We extended this study to international small-cap growth stocks and discovered a very similar pattern to that in the US (Exhibit 4).

We also extended our study to the Fama-French Five-Factor Model, which adds the two additional factors of Profitability and Asset Growth (also called Quality). In essence, Profitability (the higher the operating profitability, the better) is good and Asset Growth (i.e, the higher the capital expenditure or asset growth, the more aggressive is the firm) is bad. Regressing these two factors in the same five quintiles of the US Small Cap Growth Index reveals that ‘growthier’ stocks tend to be less profitable and more aggressive in investment.

So, how should an investor approach the small-cap growth space? Given the results I have discussed above, one strategy would be to build a portfolio that removes the ‘growthiest,’ least profitable, and highest-asset growth small companies from a plain-vanilla small-cap growth index. We have done just that, in creating a Modified Index that removes the lowest-ranking quintiles of stocks based on value, profitability, and asset growth. Exhibit 5 shows the results; the Modified Index generates a higher return with lower volatility and a much higher Sharpe Ratio than the basic small-cap growth index.

I invite you to review our recently posted underlying research paper on small-cap growth stocks.

Incidentally, I should note that, although value has a habit of prevailing over growth during a long investment horizon, I have always thought that growth stocks still merit an allocation in portfolios. After all, factor cycles (such as the growth-dominated one we’re currently in) can take years to play out and most investors are best served by being exposed to both factors.

Conclusion

Small-cap growth stocks have historically generated relatively weak investment returns. Factor analysis reveals that this pattern can largely be attributed to the ‘growthiest’ stocks in the index, which score poorly in Value, Profitability, and Asset Growth. Armed with this knowledge, we can construct a small-cap growth strategy with a substantially higher expected risk-adjusted return.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.