U.S. Small-Capitalization Stocks
In stark contrast to the efficient nature of the large- and mid-cap stock markets, the small-cap sector is intensely inefficient. There are thousands of small companies in scores of different industries, scattered all across America and frequently located in smaller, out-of-the-way communities. Investment banking firms cannot make much money on these firms, and hence investment analysts don't cover them. The only way to learn anything useful about such companies is to engage in very hard work: traveling to their locations and talking directly to the management teams, the suppliers to the companies, the customers of the companies, and the competitors of the companies. This isn't what most people think of as fun, and consequently managers who are willing to do it end up in the possession of information about small companies' prospects that is of considerable value, because it is not widely known. Indeed, history shows that, over time, smaller capitalization stocks significantly outperform larger capitalization stocks.
But before we leap to the conclusion that families should load up on small-cap stocks, let's look at the dark side of this picture. The first negative is the high price volatility historically associated with owning small-cap stocks. As we know from reading Chapter 4, investment assets that exhibit high price volatility must produce much higher returns than low volatility assets to achieve the same terminal wealth. Hence, the higher historic returns of small caps are to some extent negated by their higher price volatility.
The second problem with small caps is that, even if they ultimately produce returns superior to large caps, they can go for very long periods of time (e.g., virtually the entire 1990s) without doing so. Small cap investors, in other words, must be prepared to be patient.
Finally, there is a body of thought that argues that the superior return historically produced by small-cap stocks is a product of the fact that small-cap indexes (such as the Russell 2000 stock index) are not traded. Trading smaller securities, it is argued, is so expensive that it completely negates the superior returns offered by the asset class. A representative example is a memorandum sent by Aronson Johnson Ortiz, a (large-cap) money management firm, to its clients and friends in the spring of 2003. AJO commissioned Wilshire Associates to examine trading costs and returns across different capitalization sectors of the stock market. Wilshire concluded that the largest quintile of stocks by capitalization returned, between 1974 and 2002, only 13.0 percent, versus 17.6 percent for the smallest quintile. However, Wilshire also estimated round-trip trading costs for the largest quintile of 31 cents, or 0.8 percent of the average share price of $41. By contrast, Wilshire estimated round-trip trading costs for the smallest quintile of stocks to be 91 cents, or an astonishing 6.1 percent of the average small-stock share price of $15. This caused small-cap returns, on a net basis (“Real World Returns,” in AJO's terms), to fall below large-cap returns, 11.5 percent to 12.2 percent.6
There is clearly something to this argument. Commissions and spreads on smaller company stocks are much higher than on larger, highly liquid stocks. But the crux of the issue is market impact. Many small companies have limited stock issues and quite small floats.7 As a result, when a large money manager attempts to purchase a useful position in such a company, its interest causes the stock price to rise significantly. Similarly, when a manager believes that a small company stock has reached its full potential, the manager's desire to sell the stock seriously depresses its price. Unless the manager is very careful, the trading costs incurred in buying and selling a small-cap stock will completely offset the superior return of the stock.
My own view falls somewhere in between the argument that “small caps will always outperform in the long run,” and the argument that “the small-cap effect is completely illusory.” A small group of small-cap managers have mastered the art of trading smaller company securities, accumulating positions very slowly over time, and liquidating positions slowly and carefully. They limit turnover severely and will avoid even attractive stocks if they cannot find a way to trade them efficiently. These managers can deliver significant alpha, even net of their trading friction. On the other hand, the notion that we can simply invest in smaller stocks and sit back and watch our wealth increase is clearly delusional.
A perfectly sensible strategy in the small-cap space would be to ask our passive, tax-aware manager (see the earlier discussion under U.S. Large- and Mid-Capitalization Stocks) to manage our client's money not against the S&P 500—a pure large- and mid-cap index—but against, say, the Russell 3000, which includes smaller-cap stocks. That will give the client roughly a 7 percent to 8 percent exposure to small caps on a passive basis. We can then consider increasing that exposure by identifying one or two boutique or hedge fund managers who specialize in small caps and in whom we have great confidence.
A final issue to keep in mind in the small-cap space is that there is a huge difference between small-cap value and small-cap growth. A small-cap growth company may be a budding technology company that could either become the next Microsoft or the next Wang (which went bankrupt). A small-cap value company is likely to be making iron castings in Duluth. These are very different enterprises, needless to say, hence when we look for small-cap managers we will probably want to diversify our exposure between growth and value.8