A money manager was (supposedly) once asked how he made money in the stock market. “It’s all about animals,” he replied. “I buy sheep, and I sell deer.”
He was (of course) making a pun: He bought cheap, and sold “dear,” meaning expensive. The story is apocryphal.
My late friend Peter Bennett, who was a successful money manager in London for decades, had a similar response when a publisher asked him to write a book about how to make money on the stock market. “I couldn’t,” he replied. “It would only take one page. Buy low (ish), sell high (ish).”
All of which is preamble to today’s cheerful news for long-term investors managing their 401(k)s, individual retirement accounts and other retirement portfolios. Small-company stocks, typically meaning those of companies worth less than $5 billion, are much, much better value right now than the S&P 500, which invests in large-company stocks.
So reports Leuthold Group, a money management firm in Minneapolis that tries to bring some Midwestern common sense to the needlessly complicated world of Wall Street.
Based on trailing operating earnings, “small-caps are selling at a 25% discount to large-caps,” one of the biggest such discounts on record since at least the mid-1980s, they report. You can see their chart (above). Looking at forecast earnings for 2023, U.S. small-cap stocks in aggregate are trading at 16 times earnings, compared with 19 times for large-caps and 21 times for the biggest 50, they report.
Put another way, for every $100 invested in small-caps you are forecast to get about $6.25 in after-tax earnings, compared with about $5.15 from large-caps.
Does this constitute a buying opportunity? Should investors load up on small-cap stocks? Naturally there are downsides. Small-caps tend to be much more volatile, aka “risky,” and may well generate more short-term red ink if we go into a recession. There is also a long-running debate in finance about whether or not small-caps, over time, tend to produce greater returns as compensation for that risk.
Financial academics, with their impressively complicated research papers, disagree about whether small-caps “outperform.” The problem lies not in the complex finances but in the choice of the present tense. Common sense says that small-caps will probably “outperform” large-caps if you buy them cheaply enough, and will probably “underperform” if you buy them when they are expensive.
History suggests this tends to be cyclical. Small-caps go in and out of fashion. Kenneth French, finance professor at Dartmouth and part of the famous duo with Nobel laureate Eugene Fama, maintains data on this going all the way back to the mid-1920s. Over the very, very long term—in other words over the past 100 years—he estimates that the smallest 30% of companies on the stock market have beaten the largest 30% by an average of 5 full percentage points a year. To put this in context, that would produce twice the gains over 20 years.
There are all sorts of ifs, ands, buts and other caveats with financial calculations and my usual approach with these things is to borrow an old McKinsey phrase: I treat these numbers as “directionally correct” rather than exact. And there is no guarantee the future will look like the past.
When I spoke to French, he said the data did not show that small-caps “will” or “do” outperform large-caps, only that they have.
“The volatility of stock returns is so high, it is hard to draw inferences,” he says.
What is most interesting, though, is that French’s data show that this outperformance has been cyclical. The times to buy small-company stocks were in the early 1930s (naturally, in the depths of the great crash), the mid-1960s, the mid-1970s, and the late 1990s: The times when they were out of fashion, and cheap. Anyone who did that and held on for long enough made bank. On the other hand, if you bought them when they were in fashion, and correspondingly expensive, you got shortchanged. The worst times to buy small-caps as opposed to large-caps were the mid-1940s, around 1970, the mid-1980s, and about 10 years ago.
Even if Leuthold is right, and small-caps are now relatively cheap again, there are no guarantees that they won’t get a lot cheaper. Oh, and Leuthold is talking about relative valuations anyway. You could take their analysis to be a warning against large-caps as much as a buy signal for small-caps. Maybe small-caps aren’t cheap. Maybe large-caps are really, really expensive.
Hedge fund firm AQR estimates that any small cap outperformance has really been due to higher quality companies, meaning those with profits, stability and solid balance sheets. The overall index performance has been dragged down by all the speculative, “junk” companies. If they are right, this is a major difference between the two main small cap indexes: The S&P 600 SML,
As ever, you pays your money and you takes your choice. But it isn’t all or nothing: Investors can add some small-caps to their portfolio without abandoning the S&P 500. Leuthold’s ultimate lazy portfolio, the “All Asset No Authority” portfolio, includes equal allocations both to the S&P 500 (large-caps) and Russell 2000 (small-caps). Which makes sense.