Posted on July 13, 2007 by David Laidlaw
Very few investment strategies have been proven to work systematically over the long term. Numerous academic studies, however, have shown two persistent factors produce better than average stock returns. The first is that value stocks (those with low prices relative to book value) do better than growth stocks. The second is that small stocks produce higher returns than large stocks. Since accurate stock records have been kept, small stocks have outperformed large stocks by about 2% per year. This outperformance over the past 7 years has been dramatic. The Russell 2000, an index composed of small companies with an average market capitalization of $1.38 billion, has returned 9.95% per year since 1/1/2000 compared to the S&P 500 which has only produced gains of 0.72% per annum.
Given the current differences in valuation, we believe large capitalization stocks will reverse their losing streak and outperform smaller stocks over the next few years. This prediction stems from the fact that small stocks are now more expensive than large stocks according to their fundamentals (see table in opposite column).
A dozen years ago, small stocks sold for a significant discount to large stocks. This valuation differential seemed irrational. Small stocks should sell at a slight discount to large companies. Larger companies usually benefit from economies of scale that allow them to produce similar goods and provide like services for a lower cost than their smaller competitors. Large companies also usually have valuable intangible assets such as brand names that provide additional competitive advantages. Finally, big enterprises have the economic resources to buy small companies when they face competition and incorporate the human assets and business capital developed by smaller entrepreneurs.
Regardless of these advantages, large companies now sell for a discount to smaller companies. The following table presents a ratio comparison to illustrate this point:
*Note: Russell creates indices consisting of 1,000, 2,000 and 3,000 stocks. The 3,000 is a broad market gauge that represents about 98% of the market capitalization of US stocks. The Russell 1,000 is the largest 1,000 companies in the Russell 3,000 which comprises 92% of the market capitalization of US companies. The Russell 2,000 consists of the smallest 2,000 companies in the Russell 3,000 and represents the remaining 6% of US market capitalization.
Large capitalization stocks are less expensive relative to their earnings and dividends, but slightly more expensive compared to their book values.
We believe that the premium valuations for small company stocks are due to the expectation that these companies will be acquired at some point in the future. Both public and private acquirers usually pay more for a stock to gain control of the whole company. This makes sense since passive holders have little influence over management practices.
We also believe that these take-out premiums are not deserved and will evaporate for a few reasons. Most companies that have produced high levels of cash flow or had valuable assets with businesses that could be restructured have already been acquired. Secondly, the private equity acquisitions that have been driving the market have been financed with cheap/low quality debt. As discussed earlier, lenders are demanding higher rates so that fewer deals will come to fruition due to higher costs.
There are still many excellent small companies that are as attractive as large companies; however, on the margin, our future purchases will skew toward large capitalization stocks as long as the current discrepancies persist. For example, earlier this year we bought 3M, the large industrial company and Dow Jones component, since it is an excellent company and was selling for a compelling price. Given the cyclical nature of the performance of large stocks versus small stocks, we are sure the present trend will reverse itself again in the future and we will adjust our biases appropriately.