Investor disappointment with small-cap stocks is understandable. Although Nobel laureate Eugene Fama and researcher Kenneth French pointed out in their three-factor model proposed in 1992 that the small-cap factor should yield excess returns, in reality, small-cap stocks have performed poorly over the past decade, significantly lagging behind large-cap stocks.
However, the stock market is not like a scientific experiment, where conditions cannot be kept consistent and repeatable; investors need to adjust their strategies as the market changes. Even if small-cap stocks do not yield the 'scientifically validated' excess returns, experienced fund managers can still achieve good performance.
Since Fama and French's research, two major changes have occurred in the market. First, exchange-traded funds (ETFs) have become widely popular. A significant amount of capital has flowed into market-cap weighted benchmark indices, such as the S&P 500, which tend to invest in large stocks like Apple (AAPL.O) rather than small stocks. Second, the number and types of small-cap stocks that are publicly listed have significantly decreased.
Taking the FT Wilshire 5000 index, which covers the entire U.S. stock market, as an example, the number of stocks in this index peaked at 7,378 in 1998. When the small-cap factor was defined in 1992, the number of stocks was about 6,000. Now, affected by mergers, bankruptcies, and a decrease in new share issuances, the FT Wilshire 5000 index includes only 3,370 stocks.
The theoretical basis for the small-cap factor is that investing in small companies carries higher risks, and therefore investors should receive higher returns. However, Morningstar analyst Zachary Evens pointed out that over the past decade, the annual return of small-cap stocks has been 5 percentage points lower than that of large-cap stocks and has been more volatile. In his article, he questioned, 'Is it still necessary to invest in small-cap ETFs?' One reason is that many so-called 'unicorn' tech companies choose to remain private for the long term.
The Morningstar PitchBook U.S. Unicorn Index tracks private U.S. companies with valuations of at least $1 billion. Evans noted that the number of such companies has grown by 1,100% since 2014, while the small-cap market has shrunk.
'Over the past few decades, many companies may have chosen to go public and be included in small-cap indices. This way, these young, high-growth companies can bring long-term return potential to small-cap funds,' Evans told Barron's. If private unicorn companies like OpenAI were to go public now, their market value would exceed $150 billion.
None of this means that the small-cap factor has 'failed.' Indrani De, Global Investment Research Head at FTSE Russell, which compiles the small-cap benchmark index Russell 2000, acknowledges the increase of private companies in the technology sector, but she points out that other fields are also innovating and going public. 'There is a lot of innovative activity in the current healthcare sector, and within that sector, the weight of the Russell 2000 is expected to be higher than that of the large-cap Russell 1000 index,' she said.
FTSE Russell data shows that since 1983, the technology weight in the Russell 2000 has remained around 10%, while as of August 31, the technology weight in the large-cap Russell 1000 has grown from 4.4% to 34.2%. In the healthcare sector, the weight of the Russell 2000 has increased from 7.5% in 1983 to 17.5%, while the current weight of the Russell 1000 is 11.6%. After the pandemic, the weight in this sector has grown rapidly, with several biotech companies going public in 2021.
However, many biotech companies that went public in 2021 have had poor investment returns and plummeted in 2022. Although the Russell 2000 can be seen as a pure embodiment of the small-cap factor because it does not exclude weak and unprofitable companies, Evans prefers tracking ETFs that follow the S&P SmallCap 600 index, as this index only includes profitable companies, such as SPDR Portfolio S&P 600 Small Cap ETF.
Wes Crill, Senior Investment Director at Dimensional Fund Advisors, still believes in the small-cap factor but thinks that active quantitative screening is needed to eliminate weak companies. This is also the strategy Dimensional applies to its popular product, Dimensional U.S. Small Cap ETF. 'We find that low-profit small-cap stocks return significantly lower than other small-cap stocks,' Crill said. 'Similarly, small companies with high asset growth rates also have this issue, and they are often those that frequently acquire other companies.'
John Barr, manager of the best-performing Needham Aggressive Growth fund, noted that the passage of the Sarbanes-Oxley Act in 2002 is one reason many small companies choose to remain private, as they find it difficult to cope with the new regulatory requirements. 'Although the Sarbanes Act brought some important regulatory improvements, it also increased the cost of going public, making it difficult for small companies to stay in the public market,' he said. However, his fund holds only 87 stocks, and Barr claims there are still 'plenty of opportunities.' He prefers to select those so-called 'recession growth stocks' that have potential despite facing setbacks, rather than high-growth companies favored by venture capitalists.
Small-cap value funds have also lost some opportunities due to private equity funds acquiring cheap public companies. Aegis Value fund manager Scott Barbee stated that the emergence of private equity has not reduced the number of cheap stocks, but it has changed the types of cheap stocks available. Private equity firms typically acquire companies by adding significant leverage to the acquisition balance sheet, but this is usually limited to those businesses with stable cash flows that can cover debt costs. For cyclical companies with volatile cash flows, even if they are priced very cheaply, private equity firms often find it difficult to acquire them.
Therefore, Barbee chooses to invest in energy and mining stocks, which are more susceptible to economic changes. According to data from Morningstar, since its inception in 1988, Barbee's fund has achieved a cumulative return of 1,588%, while the return of the S&P 500 index is 736%.
Article reposted from: Jinshi Data