The small cap asset class represents companies with a relatively small market capitalization. Recall from prior posts that a company’s market capitalization is the market value of its outstanding shares. Companies are typically divided according to market capitalization: large-cap ($10 billion or more), mid-cap ($2 billion to $10 billion), and small-cap ($300 million to $2 billion). As an example, a company with 2 million shares selling for $50 each would have a market cap of $1 billion and would be considered a small-cap company. When new clients initially meet with us, we notice, even if they were working with an advisor, they tend to hold primarily large-cap stock for their domestic equity. While large-cap, often represented by the top 500 companies in the stock exchange, makes up over 80% of the domestic equity market, ignoring the small-cap asset class is a mistake.
The Role of Small-Cap in a Portfolio
As always when selecting asset classes for a portfolio it is important to understand the role you expect the asset class to play. The reasons to hold small-cap exposure in a portfolio are:
- Rounds out the domestic equity exposure to achieve greater diversification.
- Incorporates non-correlated exposure which reduces market volatility.
- Provide exposure to the “small-cap effect theory” which says that smaller companies have greater opportunity than larger companies which will result in greater potential return over time.
- Capture active management opportunity in an asset class often overlooked by investors where there are inefficiencies, attractive pricing, and sound fundamentals.
US Small Cap Premium and the Business Cycle
While it can never be known when a new contraction in the market cycle will begin or how the equity market will perform, research has shown small cap stocks outperform large cap stocks in periods leading to and through contraction of the business cycle. There is a stronger correlation between small cap stocks and the domestic economy (GDP) than with large-cap stocks which are impacted more by the global economy. An important reason for this is that small caps tend to be highly leveraged and exposed to cyclical industries so when investors become more risk adverse, they tend to shy away from small stock. Small caps began to underperform large-cap stocks in 2006 through 2008 and then again it has been underperforming since 2016.
However, as investors anticipate stronger economic performance, they are more able to take on risk to receive higher returns that small caps can provide. As we seem to be at beginning of a new economic cycle where the market is broadening out, small caps has been the top performing asset class at the end of last year and for the first quarter of this year.
What should investors do?
While we are pleased with current portfolio performance, particularly small-cap performance, we are reminded to maintain a balance in US equity exposure across the capitalization spectrum; large, mid, and small. An investor who invested 50% large cap stock and 50% small cap stock would have $536 invested with a return of 8.8%. If an investor only invested in the S&P (Large-Cap stocks) they would have $383.6 with a return of 6.9% (see figure 1). Like large-cap exposure, also consider investment style, value vs. growth. We continue to tilt towards value for our clients which is less volatile than small-cap growth. However small-cap growth can provide greater returns for those who can endure volatility.