Not to worry if small-cap stocks have been laggards for the past three years; they always do better than big-company stocks in the long run.
Or do they?
Some theorists now argue that one of the basic tenets of investing, that stocks of small companies earn the best long-term returns, is bunk. They say this famous “small-cap effect” is a myth based on a statistical misreading of history.
The biggest gun aimed at small-stock advocates is held by Jeremy Siegel, a finance professor at Wharton School of Business in Philadelphia. Siegel argues that the nine years from the end of 1974 through the end of 1983, when small-cap stocks gained an astronomical 35 percent a year, were a bizarre anomaly. Take out those freakish years, he says, and small-cap stocks have actually fared worse since 1926 than large-caps.
While the truth isn’t clear by any means, a lively debate has erupted, one with big implications for investors.
If the revisionist view is correct, then millions of investors’ financial plans scripted over the past decade are wrong, says Don Phillips, president of Morningstar Inc., a financial-publishing firm in Chicago.
Phillips says he’s less confident now that small-company stocks will win in the long run: “Markets change and evolve all the time,” he says. Unlike the laws of physics, “once you discover these (investment) principles, they mutate” because investors act on them.
Indeed, the biggest winning streak ever for small stocks ended in the early 1980s, just about the time that their long-term virtues were being discovered by researchers. It’s risky to blindly base one’s investments on the latest theories, Phillips says. “Who knows in the year 2010 what the academics will say?”
To be sure, both sides agree that most investors should own both large and small stocks. The market has always gone through cycles where big or small stocks do better for a few years. And after three years of better performance by big stocks, maybe the time is ripe for small caps.
But should investors with long-term goals like retirement load up on small stocks?
Siegel says no. The small-cap argument, he says, goes like this: If you invested $1 in small-cap stocks at the end of 1926 and held on through the end of 1996, your dollar would have grown to $3,990, assuming reinvestment of dividends. If you had put that same $1 into the Standard & Poor’s 500 index of large, blue-chip stocks instead, it would have grown to only $1,370, again including dividends.
But wait, says Siegel. “If I exclude from the end of 1974 through the end of 1983, $1 invested in small caps grew to only $263, and $1 in the S&P 500 grew to $368.” That nine-year stretch, he says, accounts for “the whole outperformance” by small caps. Since Siegel made this argument in his book, “Stocks for the Long Run,” in 1994, the numbers have gotten even stronger in favor of big caps.
What happened during those nine fat years for small caps? Big cyclical companies were hurt by oil-price increases, inflation and recession, Siegel says. And investors hated big stocks after the collapse of the “Nifty Fifty” in the early 1970s. Small caps eventually soared well over their intrinsic value, he says.
But Siegel hasn’t convinced some ardent small-cap proponents.
“I won’t support the argument that there is no such thing as the small-cap effect,” says Claudia Mott, director of small-cap research at Prudential Securities. “I believe there will still be periods when small caps will do better” than large caps, such as the three years from 1991 through 1993. And she asserts that small caps will do better in the long run.
Satya Pradhuman, manager of U.S. quantitative research at Merrill Lynch, agrees. “If you start taking dates apart, it becomes a data-mining game,” he says.
As always in quasi-religious debates such as this one, the two sides can’t even agree on the facts.
Mott, taking her numbers from the small-cap tiers of the University of Chicago’s Center for Research in Security Prices universe of U.S. stocks, says that small-cap returns still look competitive even after omitting the same nine years as Siegel. By her reckoning, big stocks would have gained 9.5 percent a year and small stocks a nearly equal 9.4 percent.
The better performance of big caps in recent years, she says, is due to a weakening dollar and the 1986 tax overhaul, which together contributed to a jump in earnings at large corporations.
Large caps also benefit from investors’ penchant for buying mutual funds that are indexed to the broader market, she says. However, index funds took in only 11 percent of the cash rolling into stock funds last year, so other money managers must have been buying big-cap stocks as well.
Mott, however, suspects that in the future small stocks won’t beat big stocks by as large a margin as they did in the past. “You certainly can question if there will be as much of a differential.”
Why should stocks of small companies perform better than those of big firms?
“Smaller companies are riskier than their large-cap brethren,” says Mark Riepe, a vice president at Ibbotson Associates. “I would anticipate that over time, investors get rewarded for taking on that risk. If they don’t get rewarded, then everybody’s going to bail out of small caps. That will drive their prices down, and there will be bargains.”
But Wharton’s Siegel contests even that assertion. “Risk depends on how you measure it,” he says. A lot of the risks of investing in small companies can be eliminated by diversification, he says. And the academic measure of risk–how widely a stock price swings–is greater for small caps than large caps when measured annually but smaller when measured over 5 or 10 years, he says.
Despite all the ups and downs, small and large stocks have earned exactly the same return since December 1978, points out John C. Bogle, chairman of Vanguard Group, a big mutual fund company in Malvern, Pa. Bogle says the claims by small-cap advocates have been deflated.
“If you go back to 1926, small caps did much better,” Bogle concedes. “Is the old data reliable? Who knows?”
