Big Caps v. Small Caps - Expected Future Returns

Posted on December 17, 2010 by David Laidlaw 

Equity markets are sliced and analyzed according to many different criteria.  Market capitalization is one of the most fundamental factors used to segregate stocks into different categories.  Morningstar’s style box is a prime example of the use of market capitalization to define investments.   Investors move funds between Large, Mid and Small Capitalization stocks at different times hoping to increase their returns. 

Throughout the past market cycle, small capitalization common stock returns have trounced the returns generated by large capitalization stocks.  Following is a table of annualized returns over the past 10+ years comparing the Large Cap Russell 1000 with the Small Cap Russell 2000:

While the values for the majority of large cap stocks have stagnated, those for smaller companies have almost doubled since December 31, 1999 (see the performance calculator on Russell’s web-site to test other periods). 

Comparing fundamental valuation metrics, large capitalization stocks are more attractively priced.  The following table compares the two indices: 

Russell 1000 Fundamentals

 Russell 2000 Fundamentals

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 While small caps sell at a discount to large caps on a book value basis, large caps are much cheaper on an earnings basis and provide a higher dividend yield.  Large cap stocks’ earnings per share have also grown about 25% faster over the past 5 years. 

In the near term, small capitalization stocks may continue to outperform large caps.  Small caps are viewed as better bets during the early stages of an economic rebound since smaller companies are more nimble and able to shift their businesses to take advantage of growth opportunities.  Small caps are also benefiting from positive momentum that can be self-sustaining since investors tend to crowd into sectors that have performed well.

Over the long term, however, we believe that large caps will outperform small caps.  Their valuations are more attractive and their cash yields are more generous.  Large stocks also have a higher percentage of their sales in rapidly growing emerging markets, while small caps, in general, are more reliant on domestic markets for their goods and services.  Higher overseas growth relative to the US will aid large caps to a greater degree than smaller stocks.  Finally, large capitalization stocks deserve a slight premium since most businesses benefit from economies of scale and that advantage tends to be persistent.