October 20th, 2017 | by Gregg S. Fisher, CFA, "Invest with Reason"
After a Decade of Strong Large Cap Growth, is There a Place for Small Value in Your Portfolio?
- The recent outperformance of favored tech stocks is the latest blow to small-cap value in a decade-long pattern biased toward large-cap growth.
- Indeed, although small-cap value has historically outperformed large-cap growth by a five-percentage-point annualized premium, that advantage turned to a deficit over the past 10 years.
- But any given 10-year period is idiosyncratic, subject to the whims of investor behavior. In rolling-10-year periods over the last 30 years as well as very long-term, small-cap value outperformed large-cap growth an overwhelming majority of the time.
- At Gerstein Fisher we believe that investors are bound to once again demand more return for taking on the extra risk of small-cap value. Although we can’t say when this will happen, the investor herding we’re seeing into large-cap growth may suggest that the tables may be poised to turn.
- But while we would counsel investors not to abandon small-cap value in this difficult cycle for the style, we would also recommend holding multiple equity asset classes, including large-cap growth. For most investors, a multi-style portfolio is a better, less-volatile, choice than loading up on stocks of any one type, whether popular or not.
This year’s stock heady market rise has been powered by the technology sector, which now accounts for nearly one-quarter of the entire S&P 500 Index by market capitalization. The four so-called FANG stocks (Facebook, Amazon, Netflix, Google/Alphabet) alone generated two percentage points of the S&P 500’s 14% gain this year through September. Indeed, large-capitalization growth stocks are on quite a roll. In the 10 years from September 1, 2007, through August 31, 2017, large-cap growth returned 9.9% annualized, compared to just 7.2% for small-cap value stocks (Source: Ken French’s website), which historically have been the best-performing US equity asset class. In other words, during the past decade, the “small cap premium” has become a deficit of 2.7 percentage points. Is it time to throw in the towel on small caps?
Before I address that question, let’s review a bit of market history. From January 1927 through August 2017, small-cap value returned 14.7% annualized versus 9.6% for large-cap growth, a wide 5.1 percentage-point premium, according to French’s research. It was in 1993 that French published a landmark research paper* with Eugene Fama (who was awarded a Nobel Prize in Economics in 2013) on the three-factor model, which asserted that investors could earn a higher return by being exposed to the extra risks of value stocks (e.g., those with a low price-to-book ratios), smaller-cap companies, and the market itself (as opposed to “safe” assets such as Treasury bills).
I should emphasize that by being different from a benchmark (which is the investment approach of factor-based investors such as Gerstein Fisher), portfolios may outperform for periods of time—or underperform; investors must accept the downside possibility as well as the upside opportunity. And as we saw over the last decade, the downside can go on for a while. But although a 10-year investment horizon is reasonably long, any specific decade is bound to be idiosyncratic and not necessarily indicative of what to expect going forward (for example, the past 10 years happened to encompass the 2008-2009 global financial crisis and epic stock market crash). Still, we believe that the math continues to favor portfolios that tilt toward “small” and/or “value” factors.
Cycles and Market History
With that in mind, we conducted several studies of premiums over time periods that are more useful than any one specific trailing- 10-year period. Exhibit 1 compares the historical premiums and deficits of small-cap value stocks over large-cap growth using 10-year rolling periods since September 1987, moved forward one month at a time. The exhibit illustrates some pronounced cycles in both directions, but makes clear that small-cap value outperformed large-cap growth in an overwhelming majority of the 10-year periods. Over the past 30 years, the 10-year gap between small value and large growth oscillated between an annualized premium of 14 percentage points and a deficit of six points.
If we extend our analysis back to1927 (when reliable data became available), we can see that the longer the investment period, the greater the likelihood of a small-value strategy outperforming a large-growth counterpart (see Exhibit 2). And so, for example, over one-year rolling periods, small-cap value and large-cap growth each won close to half the time, but over 10-year periods, value dominated with almost a 90% win ratio.
I have no idea when the cycle will turn again toward small-cap value, but I do note a recent pattern of investor herding (which often is a prelude to a sharp correction) in the large-cap growth space. (For more insight on the pitfalls of “crowded trades,” see my recent column on behavioral-finance pioneer Richard Thaler, “Richard Thaler’s Well-Deserved Nobel Prize”). In fact, our research shows that investors’ collective appetite for higher valuations has grown over time, and that the gap between the lowest- and highest-valuation securities in the US market, using price/book ratios as a touchstone, has never been larger than it is right now (see Exhibit 3).
In closing, I should note that, while the argument for small-cap value is historically compelling, I do not recommend that investors abandon growth stocks and load up on small-value shares. Particularly due to the possibility of pronounced factor cycles and the behavior biases of investors, I believe that some combination of multiple equity asset classes, is a better solution for most investors, not least because it will likely smooth out short-term portfolio volatility. At Gerstein Fisher, we believe that the “right portfolio” identified as optimal by orthodox portfolio theory, is not the best one if for any given investor if he or she is unwilling (or unable: not every investor has an extended time horizon) to stay invested in it for the long term. For more on the comparison between large-cap growth and small-cap value, I invite you to read our research paper, “After a Decade of Strong Large Cap Growth, Is There a Place for Small Value?”
*Fama, Eugene F., and Kenneth R. French, 1993, “Common Risk factors in the Returns of Bonds and Stocks”, Journal of Financial Economics 33, 3–53