Will Small-Cap Stocks Continue To Outperform?

The so-called small-cap equities premium in recent years has, in some circles, been dismissed as an anomaly that’s faded since the academic literature first documented the risk factor in the early 1980s. The change of heart is understandable, given the relatively weak performance for small firms vs. the broad market, large-cap shares in particular. In fact, small caps deserve a closer, more nuanced review – a review that suggests that dismissing the small-cap premium may be hasty.

For starters, it’s crucial to recognize that not all small-cap stock indexes are created equal. Indeed, some if not most of the disappointment with this slice of the equities market in recent years may be due to focusing on a definition of the small-cap universe that’s impractical for investing, even if it’s appropriate for benchmarking. By contrast, a 2015 study by researchers at AQR Capital Management advised that the weak performance of small caps is a function of low-quality firms. “Controlling for quality/junk” is linked to a “significant size premium,” the authors report in the “Size Matters, If You Control Your Junk” paper.

Using an ETF proxy for so-called quality small caps shows that this corner of the equities market has, in fact, outperformed a broad measure of stocks over the past quarter century, assuming a buy-and-hold strategy was employed (see chart below). The iShares Core S&P 600 ETF (IJR) tracks the S&P SmallCap 600 Index, which screens for companies with positive earnings – in contrast with some small-cap indexes that simply include all small-caps as a matter of comprehensive benchmarking. The earnings filter appears to have played a role in IJR’s relatively strong performance vs. a proxy for the overall stock market, based on the SPDR S&P 500 ETF (SPY), which tracks the S&P 500 Index, a large-cap benchmark.

That’s not to say that IJR always outperforms. In fact, the ETF’s history since its launch in 2000 has witnessed several cycles that alternate between small-cap outperformance and underperformance vs. big caps, based on SPY.

As the next chart below indicates, there have been three primary cycles for IJR vs. SPY since 2000. The first lasted more than decade before it gave way to a period of consolidation, during which the two funds basically generated comparable performance during roughly 2010-2018. Following that period, small caps started to underperform and it’s not clear that the relative weakness has ended.

But there are hints that 2024 may be a turning point that marks the start of a new regime of small-cap outperformance. Over the past month, IJR has dramatically outperformed SPY: 11.5% vs. an essentially flat performance for SPY, through July 26.

It’s too early to say if we’re in the early stages of a new extended period of small-cap leadership, but there are some encouraging clues. The first hurdle is whether the recent outperformance persists in the weeks ahead.

One reason for speculating that a turning point has been reached: the underperformance may have run out of road, considering the long-running outperformance in large caps. Trees don’t grow to the sky, as the saying goes.

Meanwhile, small-cap leadership seems to arrive in waves. History suggests there are periods, for a variety of reasons, that favor small caps, interrupted by periods when the opposite prevails.

Another factor: small cap valuations are inexpensive relative to the large-cap brethren. IJR’s trailing price-earnings ratio is 14.4 vs. 22.0 for SPY, according to Morningstar. That alone doesn’t ensure outperformance, but it helps tip the scale.