The tide has turned
Last year, as we all know, was not the time to be in US stocks. The S&P 500 Stock Index lost over 9%. The Nasdaq fell a dizzying 39%. Giants such as Xerox, AT&T and Lucent fell to a fraction of their peak values – to say nothing of the dot.coms. The US equity market was definitely not producing the kind of double-digit performance investors have become accustomed to of late.
Or was it? Consider that, while the large-cap S&P 500 lost 9.11% in 2000, the S&P MidCap 400 Index actually gained 17.51%. From mid-January 2000 onward, mid-cap stocks consistently outperformed large-caps. And, on a relative basis, small-cap stocks also fared well. The Russell 2000 Index of smaller companies fell only 3.02% over the past year.
At the end of 1999, we made the statement that “European investors who have allocated their US exposure solely to large-cap equities, particularly through S&P 500 indexed mandates, may be exposed to greater risk than they anticipated.” In 2000, this warning was borne out. Investors who allocated 100% of their US equity investments to the S&P 500 lost over 9%. Had those investors allocated 30% of their US portfolios to smaller companies, equally divided between the S&P MidCap 400 and the Russell 2000 Indexes, those losses would have been cut by more than half.
By the end of 1999, valuations for large-cap stocks relative to smaller company stocks had reached historic highs. Both fundamental and technical factors contributed to this growing disparity.
Productivity gains throughout the 1980s and 1990s played a large part in accelerating corporate earnings. Rising productivity allowed companies to raise both wages and output, keeping these elements in rough balance. Inflation did not accelerate. As a result, US interest rates could be kept low by the Federal Reserve. Low interest rates and the accessible credit created by low rates fed increasing consumer and capital spending growth. Rising demand and continued improvements in productivity resulted, completing the ‘virtuous circle’ that characterised much of the American economy in the second half of the 1990s.
One consequence of the virtuous circle was that companies were able to forecast future growth with increasing confidence. Quarter after quarter, companies would achieve earnings that outstripped even the optimists on Wall Street. As track records of ‘beating the street’ grew longer, investors became more willing to put money into these companies.
The companies investors heard the most about were, of course, the largest companies. ‘Bellwether’ stocks in the S&P 500 Index benefited disproportionately from their high level of visibility. Investors sought convenient and ‘safe’ ways to participate in these benefits, leading to a rise in the popularity of index funds. On a technical level, the sheer flow of money into S&P 500 index funds was enough to inflate valuations for those stocks. Non-US investors were also drawn to large, well-known companies, adding another cash flow. Finally, ‘momentum’ investing came into fashion. Stated simply, momentum investors buy whatever is going up. The notorious day trading phenomenon was one example of momentum at work. As the S&P 500 continued to grow, momentum cash flows into its component stocks became greater and greater.
Clearly, the level of investor frenzy surrounding the S&P 500 was nothing like the hysteria that attended the Nasdaq and the dot.coms. But even among the established blue chips, imbalances between valuations and underlying corporate earnings were coming into being – imbalances that could not be sustained. In 2000, as is now clear, the pendulum began to swing back.
For small and mid caps the 1990s were also good. Smaller companies gained a great deal from rising productivity and demand, as well as easy access to credit. With smaller, often younger and technologically literate workforces, smaller companies adapted well to changing markets without incurring the immense restructuring costs that larger companies often had to bear. Long-term growth rates reflected these advantages. For example, in December 1999, the average growth rate of the stocks in the small-cap Russell 2000 Index was 22.2%, versus 17.2% for the stocks in the S&P 500.
The stocks of smaller companies likewise benefited. In reviewing market performance throughout the 1990s, it is important to note that, with the exception of 1998, both major smaller-company indexes posted double-digit gains during the same periods that the S&P 500 did (Table 1).
Performance is clearly there. The difference is relative. Though smaller companies benefited from the 1990s bull market, their earnings growth was rewarded relatively less than the earnings growth of larger companies.
Why? The two primary issues appear to be volatility and visibility. Of these, volatility is probably the most important. Most S&P 500 companies are, after all, blue chip companies. They are large, liquid and have proven records of earnings and performance. Price movements for the S&P 500 are significantly less volatile than the price movements for the Russell 2000 over short periods.
Smaller companies rarely have the kind of ‘headline’ recognition of larger companies, and so visibility is also lacking. A host of small technology companies do not have the cachet of a name like Microsoft, which means that exceptional growth and strong niche market positions often go overlooked. This was the case through most of the 1990s. The relative valuation of smaller companies fell steadily from 1995 through 1999, even as all indexes notched up successive years of excellent performance. Again, this was an imbalance that could not persist.
The small-cap cycle
Smaller company outperformance tends to occur in cycles that counterbalance periods of outperformance by large-cap equities. This point is best made by looking at actual investing experience. Because the most widely-used benchmark of small-cap performance, the Russell 2000 Index, has only been in existence since 1978, those who are interested in longer-term small-cap performance have traditionally looked to the T Rowe Price New Horizons Fund for empirical data.
The New Horizons Fund, which was established in 1960, is a growth-oriented small-cap fund that is actively managed on the basis of fundamental research. Over time, the price to earnings ratios for the stocks in New Horizons have typically ranged from 1X to 2X the ratios of large-cap stocks (see Figure 1). Periods of rising relative P/E ratios correspond to periods when small-cap stocks outperformed large caps; conversely, when relative P/Es have dropped, small caps have underperformed.
Our total return performance table shows the magnitude of these cycles. Performance spreads between the two asset classes have at times exceeded 250 percentage points. Such huge cyclical disparities highlight the need to be invested at both ends of the capitalisation spectrum. It is also worth noting that the three widest spreads over the past 39 years have all favoured small-cap stocks (Table 2).
A crucial point is that the beginnings of the four major cycles of smaller company outperformance – in 1964, 1970, 1976 and 1990 – have coincided with periods when the P/E ratios of these companies approached parity with those of large caps (1.0 on the chart). The most recent data, which shows a sharp rise in the relative P/E, correlates with the strong performance of smaller company stocks in 2000. Note, too, that even now the relative P/E measure is still at less than half of its usual historical peak for an outperformance cycle. Likewise, in terms of performance spreads, small-cap cycles have typically achieved a triple-digit advantage over large caps during their cyclical peaks. Thus far, the current cycle is showing a 35% advantage. This may indicate that we have significant potential for continued outperformance in the quarters ahead.
The case for smaller company investing
In a US equity market that contains over 6,000 listed stocks, only 248 companies qualify as ‘large cap’ – that is, have a market capitalisation of more than $10bn. Smaller company stocks account for 96% of publicly traded companies, but only 26% of total US market capitalisation (Table 3). Why should so small a percentage of the market command an investor’s attention?
In a word, performance. Many well-managed smaller companies have better internal growth prospects than large companies in mature industries, and thus command higher price-to-earnings multiples once their ability to grow has been demonstrated.
Since our 1999 report, the number of companies on the major US stock exchanges has dropped by 732, with almost all the decrease occurring in the small- and mid-cap range. Total market capitalisation, however, has jumped by $1,435bn. This is indicative of another driver of small-cap outperformance – mergers and acquisitions. As industry consolidation occurs, smaller companies are often taken over for significant price premiums.
Historical research bears out the potential for small-cap outperformance. The historical case for investing in smaller company stocks was succinctly made by Claudia Mott of Prudential Securities in her analysis of data from the University of Chicago Center for Research in Securities Prices. Since her original study in the early 1990s, T Rowe Price has continued to update the data. The results show that small-cap stocks have returned an average of 11.73% per year since 1926, versus 10.47% for large caps. Compounded over time, that 126 basis points of spread becomes a tremendous performance advantage.
Where to start
Successful smaller company investing is based upon recognition of solid growth opportunities, and management of the inherently greater risk that such opportunities carry. The truism most often quoted for small-cap equities is simple and stark – “Companies either grow up or blow up.” To distinguish between the two requires individual company research.
A major reason why small-cap equities tend to outperform large-cap equities over the long term is because the immense and shifting market of smaller companies is so inefficient relative to the large-cap universe. Large companies are the focus not only of regulatory scrutiny, but of analytical and public scrutiny as well. No event is overlooked, and information is instantly disseminated.
While smaller publicly traded companies in the US are held to the same high reporting standard as large companies, sheer numbers ensure that not every company receives a similar level of analytical scrutiny. Companies under $1bn in market capitalisation, for example, average three Wall Street estimates, as compared with 20 or more for the average large-cap company (according to I/B/E/S data). Many companies have no Wall Street coverage whatsoever.The information is there – but often, no one is looking.
It takes a significant commitment of firm resources to assemble a credible and effective research team for smaller companies. Experience and a strong network of contacts count. A hands-on approach – visiting companies, touring their operations, meeting managers and workers, talking to suppliers and competitors and participating in industry events – is critical for uncovering the hidden value that marks a small-cap winner. Likewise, experienced judgement based on solid information serves as an investor’s best hedge against risk.
The case for mid caps
Even when an asset manager can offer solid smaller-company research and an experienced investment team, however, the volatility of small-cap stocks can still be too high for some investors to tolerate. The Prudential/University of Chicago data also show that small-cap stocks had a standard deviation of 26.96%, versus 18.24% for large caps, over the period 1926–2000. Additionally, some small-cap stocks are very thinly traded. This inefficient market is one of the reasons why so much opportunity can be found in the small-cap area, but it also means that some investments can be relatively illiquid.
As the investment community has sought a systematic way to participate in the growth potential of smaller companies while reducing the inherent risk of small caps, a focus on companies with intermediate market capitalisations has developed. Mid-cap equities are now tracked by several recognised indices, most notably the S&P MidCap 400 Index (established in 1991).
Mid-cap equities have a market capitalisation roughly between $1bn and $8bn, with some mid-cap investors including stocks of up to $10bn in capitalisation. Many of these companies have ‘grown up’ through the small-cap ranks, and therefore have significant operating histories and proven business concepts. Mid caps also tend to have higher trading volumes, making them more liquid investments. The mid-cap market is thus more efficient than that of small caps, but is still less efficient than that of large caps, leaving substantial room for opportunity.
The Prudential/University of Chicago study shows that, over the long term, mid-cap equities have on average outperformed large-caps by 115 basis points per year, capturing a substantial portion of the small-cap premium. Yet volatility, at a standard deviation of about 23%, has been substantially less than the small-cap average.
It is this kind of performance that has created the rapid acceptance of the mid-cap asset class among investors and consultants alike. It also makes mid caps an attractive way to participate in US smaller company investment for those European investors who are more risk-averse.
The elements may now be in place to create an environment in which US smaller company stocks may realise their full potential. Valuations, while off the market bottom, are still compellingly low relative to large caps. The US economy is looking ahead from current recession to a period of new growth, and with interest rates low, smaller companies will have access to the credit they need to take advantage of growth opportunities. Rising productivity and industry consolidation are two long-term trends that should continue to benefit performance into the foreseeable future.
And, perhaps most importantly, the risks of concentrating a US equity allocation in large-caps have just been convincingly—and painfully – demonstrated. The motivation for re-evaluating a US equity allocation is still fresh. Unquestionably, now is the time for investors to consider how best to position their portfolios to take advantage of US smaller company opportunities.
R Todd Ruppert is president and CEO of T Rowe Price Global Investment Services. ©2001, the T Rowe Price Group. The T Rowe Price Group includes T Rowe Price Global Investment Services Limited, T Rowe Price Associates, Inc, T Rowe Price International, Inc, and T Rowe Price Stable Asset Management, Inc. T Rowe Price Global Investment Services Limited is located at 60 Queen Victoria Street, London EC4N 4TZ, and is regulated by IMRO