Many investors, even professionals, have an investing size and/or style they favor. Large cap. Small cap. Small value. Mid-growth. Maybe they’re more specific—only investing in large Tech firms. Small Midwestern banks. Mid-cap Consumer Discretionary, but only if they’re value and German.
Money managers and mutual funds often offer “products” adhering to strict size and/or style guidelines. And there’s nothing wrong with that. That’s how the institutional world functions and has for decades. Except, typically, institutional clients will ensure they have exposure to essentially all the major styles and sizes (growth and value in small, mid, and large cap, domestic and foreign, and all the standard sectors). When institutions do that, they typically either do these slices passively or hire what they consider to be best-of-breed portfolio managers in each category. But many individual investors, even professionals, mistakenly think their favored size and/or style is tops—the best for all time—and will continue being best going forward. And they invest solely or mostly in that particular size/style/category. A major mistake!

Chasing Heat

Interestingly, for most folks, attachment to a category usually coincides with a run in that size/style that has gone on for some years. At the end of the 1990s, plenty of folks were hot on large growth stocks—because large growth had done so well for so long—and particularly those with a Tech tinge. Except, shortly thereafter, large growth and Tech got crushed in the 2000-2003 bear. In the early 2000s, small cap was a favorite again. Then, for most of the 2003- 2007 bull market, foreign stocks led the way. Suddenly everyone wanted foreign and you heard endlessly how the US was done. (A repeat of what folks said during the 1980s, only to see the US lead for most of the 1990s.) Then, in 2008, foreign stocks were among the worst categories.1
That’s not to say a hot category must turn cold next year. No! The point is: Some categories lead for a long time. When they do, they gather adherents who want to think that category is simply and inherently superior—forever. Pure bunk!
Figure 10.1 looks like a crazy mish-mosh quilt with no discernible pattern. It shows major asset classes (large cap US, large cap foreign, large US growth, small value, bonds, etc., etc.2) and how they performed each year relative to other categories (the best category each year is on top, the worst on the bottom). So, in 1990, bonds did best (Barclays Aggregate is an investment-grade bond index), and foreign stocks (MSCI EAFE) did worst. The boxes move around. Sometimes one style does best for a while, then gets buried. But no one box dominates.
All major categories (properly constructed) change leadership, irregularly. Nonetheless, folks love citing data supporting their beloved category. For example, it’s true that since 1926, small cap stocks have outperformed the market as a whole! 3 Evidence small cap is inherently better—or is it? A lot of that outperformance is tied to terribly tiny stocks—ones most investors wouldn’t hold because of illiquidity issues and increased risk. Plus, early on, tiny stocks had huge bid-ask spreads that ate up return if you actually bought and sold them, but aren’t adjusted for in index returns. In the 1930s and 1940s, when much of that supposed outperformance occurred, bid-ask spreads for the small stocks involved were often 20 percent to 30 percent of the price of the stock! So if you actually bought them, there went the return. Then, too, small cap stocks tend to lead early on coming out of bear markets. If you strip out the biggest small cap booms (1932-1935, 1942-1945, 1974-1976, and 2002-2004), large cap stocks overall beat small caps—and typically for agonizingly long periods. And if you can time markets well enough to pick those times—the early phases of new bull markets usually—there are lots of other ways to beat the market too.
If you believed the hype that small cap or even small cap value stocks are permanently better based on the averages, you likely went through agonizingly long periods when you got whacked by other styles. (Another debunkery trick: Always look beyond the averages to what makes them up.) For example, from the mid-1980s through 2000, a very long time, small cap value lagged badly. By 2000, few believed in small value—everyone was hot on big cap and Tech—almost the exact opposite of small value! (I admit, I’ve always loved small value. It’s where I got my career momentum, and my firm still manages billions of dollars in that style. But I don’t and haven’t believed in decades that it was somehow long-term superior. It’s just another category).
Figure 10.1 No One Style Is Best for All Time
Source: Thomson Reuters.2
Large cap isn’t inherently better either—although there is a huge realm of investors who think so. All equity categories, over very long periods, should net similar returns, though taking different paths. Why? Supply and demand. Also, investment bankers.

Supply and Demand (and Investment Bankers)

Stock prices, like everything else we buy in free markets, are driven by supply and demand. Near term, stock supply is relatively fixed. Initial public offerings (IPOs) and new stock issuances take tremendous time, effort, and regulatory input—and they get announced well ahead of time, so over the next 12 to 18 months, you don’t get big, unexpected stock supply swings. That’s when demand rules, driven largely by fickle sentiment—getting more positive or negative—which can happen super fast. (Remember the big, fast 1998 correction in Bunk 7? That’s how fast sentiment can move.)
But longer term, supply pressures simply swamp all else. Stock supply can expand or shrink nearly endlessly over the long term in perfectly unpredictable patterns—increasing through issuances or shrinking through buybacks and cash- or debt-based takeovers. And for supply, you need investment bankers. Investment bankers are much maligned as I write in 2010, but they serve a useful societal purpose in helping firms access capital markets. And you want firms to have access to capital markets so they can grow, innovate, hire more people, and so on—or to buy back their stock when it is too cheap, or take over competitors when they’re too cheap. (If you don’t like those things, you need a different book and maybe a therapist.) And investment bankers, like most everyone else, like turning profits. And they do it, in part, by helping firms issue new shares or new debt (or in some cases by destroying supply of securities through buybacks, mergers, acquisitions, etc.).
So when one category starts getting more interest—like Tech in the late 1990s—investment bankers meet that demand by helping new firms in that hot category go public, creating new supply in that category, which dilutes future returns. As that happens, established firms in that same category see how cheap and easy it is to raise money, and they start issuing new shares—raising capital for research and development, capital investment, mergers and acquisitions, whatever. The investment bankers keep printing new stock for both new and established firms until, ultimately, supply swamps demand and prices fall.
Sometimes they fall slowly, sometimes quickly—but demand falls and investment bankers don’t want to issue shares for the cold category as much anymore. They want to issue shares for the next hot (or even warm) category—increasing stock supply there. Meanwhile, excess supply in the now-cold category can get swept up as corporations buy back shares or go bankrupt or get swallowed by other firms in cash takeovers. Supply can expand and contract endlessly and, in the long term, will overcome any major shift in demand.
And because firms will always be motivated to raise capital at different points, and because investment bankers will always be motivated to help firms who need (or want) to raise capital by issuing shares to meet demand (or manage buybacks and takeovers for firms), future supply will always be unpredictable but overpowering in the longer term.
Demand should float from category to category irregularly. There’s no inherently fundamental reason why, 10 years from now, investment bankers should want to issue more shares of Tech versus Energy versus a larger category like small cap or large. Each category—if well constructed—should travel its own path but net very similar returns over über-long periods, as the forces of supply ultimately drive long-term returns.
Maybe one style, size, category, or sector leads for a long time—longer than you’d think—but you never want to fall in permanent love with any, because leadership rotates. Always.
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