Should You Bet On Small Cap Growth Stocks? Why It May Not Be A Good Option Now

July 18, 2016

Should You Bet On Small Cap Growth Stocks? Why It May Not Be A Good Option Now

  • Small cap growth stocks only outperform in the two years after market bottoms.
  • At this moment they provide more risk and less returns than the S&P 500.

Introduction

While it’s possible to make money in the stock market, it’s not easy. One thing an investor should know well, and constantly assess, is their exposure to various kinds of stocks, from value and growth stocks to large or small caps. Each type of stock performs differently depending on the economic cycle. However, over the long term small caps and value stocks have outperformed the rest of the market.

In this article we are going to investigate what we might expect from small cap growth stock performance at this moment in the economic cycle.

Small Cap Growth

Small cap growth stocks are companies whose earnings are expected to grow at an above average rate, relative to the market and their market capitalization, which is typically less than $2.5 billion. These companies have tremendous potential and if they manage to become large cap stocks, the returns to shareholders are phenomenal. This is magnified by the fact that mutual funds are often restricted in buying small caps and thus as a company grows there are more and more buyers who can invest.

While the returns of investing in small caps can be very rewarding, the risk is also higher than with large caps. Since the business isn’t as well established, there is a lack of corporate transparency, and more difficulty in attracting capital.

The chart below shows how small cap growth stocks have performed in various cycles since 1980 in comparison to the S&P 500.

figure 1 small cap vs sandp
Figure 1: $100 invested in the S&P 500 vs U.S. small cap growth stocks in 1980. Source: Fidelity, iShares, Author’s Calculations.

In the long term, the S&P 500 outperformed small cap growth stocks even with the standard deviation of returns being much lower (22.33 for small cap growth and 16.2 for the S&P 500). A higher standard deviation of returns means that you can expect more volatility, thus more risk, but as we can see it does not translate into higher returns over the long term. A higher standard deviation means that there will be periods when small cap growth stocks outperform.

In researching the performance of small cap growth stocks through economic peaks and troughs, the conclusion is that small cap growth stocks outperform other types of stocks in the short period after recessions. Investing $100 in small cap growth stocks at the beginning of 2009 would have returned $181 in the next two years and largely outperformed the S&P 500’s $144. However, from 2011 onwards the S&P 500 would have outperformed small caps by 10% in total.

The same situation happened after the 2003 bottom where small cap growth stocks returned $175 for a $100 investment in the two years after 2003 and outperformed the S&P 500 which returned only $142. The same holds for the 1991 recession with two year returns at $170 for small cap growth stocks and $139 for the S&P 500.

So one thing is pretty clear: small cap growth stocks outperform after the economy and the markets have reached their bottom. This is good to know for future recession lows, but does not help much in the current seven-year bull market.

By looking at the data from 1980, small cap growth stocks have underperformed in all the stable growth periods from two years after the bottom to the peak of the market. They also underperform in bear markets and flat markets.

figure 2 performance in bad years
Figure 2: Small cap growth performance in bad and stable years. Source: Fidelity, iShares, Author’s Calculations.

This means an investor would do well to avoid small cap growth stocks at all times except for the darkest recession and bear market periods.

Rationale

Given that long term returns are correlated to underlying earnings, the first thing to consider in order to better understand the performance of small cap growth stocks is valuations. The iShares S&P Small-Cap 600 Growth ETF (NYSEArca: IJT) has a PE ratio of 24.29 and a Price to Book ratio of 2.9, while the iShares Enhanced U.S. Large-Cap ETF (NYSEArca: IELG) has a PE ratio of 19.84 and a price to book ratio of 2.3. Higher valuations make small cap growth stocks riskier, and at the first sign of a recession or tightening of financial markets, investors flee small cap growth stocks, which is the reason for their underperformance in flat and bear market years.

The reason they outperform in the recovery phase of an economic cycle is derived from the above. Since small caps are battered in recessions, their recovery is much better as they start from a lower starting point and have to play catch-up. As soon as they catch up, they begin to underperform as their valuations are usually too high.

figure 3 economic cycle
Figure 3: Stock types and economic cycles. Source: BlackRock.

Also, large caps are more globally diversified and derive about 38% of their revenues from abroad. Small cap growth stocks are mostly concentrated on their focus market and do not have the benefits of international diversification to help them in case of a U.S. recession.

What To Do

Passive investors should rethink their exposure to small cap growth stocks. As most, if not all of the extra returns from the 2009 recession low have been made, they now offer a lower return for more risk than a boring investment in the S&P 500.

However, there is one caveat. During moments of an economic peak like today, merger and acquisition activity intensifies, which should give a boost to small cap growth stocks. If you hold a portfolio consisting of many small cap growth stocks, you might want to select the ones that have a higher chance of being bought out by a bigger company.

 

By Sven Carlin Investiv Daily Market Forecast Small Caps Share: