Investing in large or small stocks?

In this article, we will go a little deeper into the stock class specifically. The question then quickly becomes: what type of stocks are "the best"?

KIeine or large companies?

A classic debate is whether it is better to invest in stocks of small companies ("small caps"), or of large companies ("large caps")? The classic literature assumes that stocks of small companies generally do slightly better: Fama & French published back in 1993 their world-renowned article showing that small cap stocks of smaller companies do slightly better over the long run than large caps.

An analysis of the European market over the period 2000-2024 confirms these findings. We see that small companies in Europe significantly outperformed the large cap index over the entire period. The European Small Cap Index realized an annualized return of 7.44% compared to 3.90% for the broader MSCI Europe. Looking at more recent (2016-2024) data, this picture needs some nuance. The flow of money towards large market capitalizations is evident since 2016 and accelerated in the post-Corona era which lifted the return for large listed companies above that of the small ones.

Looking at the United States, we see a similar trend, but very much more accentuated compared to Europe due to the extremely strong stock market momentum within the "Big Tech" segment.

Over the period from December 1999 to the end of February 2024, we see that the returns of large versus small companies have been almost identical. The S&P 500, the U.S. stock market index that includes the 500 largest companies, was able to post annual returns of 7.48% over that period. For the Russell 2000, an index of 2,000 small and medium-sized U.S. companies, the return over the same period was 7.43%.

However, that masks major intermediate differences. Until the end of 2016, the mantra was "Small is Beautiful." The Russell 2000 achieved a 7.39% annualized return during that period, while the S&P500 made do with 4.51%. Since then, however, it has been the largest companies that have been making the beautiful weather. From 2017 to the present, the S&P500 achieved an average annual return of as much as 14.28%. The return of smaller companies was orphaned at 7.51%. Although that return was almost perfectly in line with its longer-term average return.

3 reasons can be cited as explanations for this:

1. Major technology stocks have been posting phenomenal returns in recent years. Helped by covid and more recently by technological breakthroughs in artificial intelligence. The recent stock market performance of the 'magnificent seven', the seven largest U.S. technology stocks, attracted almost the entire return of the stock market index. Not that technology is absent from small companies: it is the 4th largest sector in the Russell 2000, weighing in at 13.6%. But partly because of the boom of "the seven," the technology weight in the S&P500 has since risen to a whopping 29.8%.
2. The regional banks in the U.S. had a hard time in recent years. Providing long-term loans and funding that with short-term deposits, there had to be chunks of that when interest rates started their steep rise. And those regional banks are mostly contained in the small cap indices.
3. The Russell 2000 also has a stronger weighting toward real estate. Again, a combination of covid and rising interest rates made both the office market and shopping centers particularly hard hit.

This caused the performance of small cap indices to lag that of large caps. Which, in turn, caused a pull effect: rising indices attract new investors, creating positive momentum and also driving up valuations further.

What will the future bring? We can only note that the valuation of large caps has risen sharply in recent years and the difference in valuation between large and small companies is now close to historical maxima. Whereby the valuation of many small companies is at normal to cheap levels, while that of the largest companies seems rather expensive.

Value or Growth? Quality!

Another finding in Fama & French's academic study is that 'cheap' stocks outperform 'expensive' stocks on average. This is often translated to 'value' versus 'growth.' Where value, that is, cheap stocks, historically did slightly better over the long term.

At Value Square, however, we find the split of stocks into 'value' versus 'growth' somewhat poorly chosen. The naming seems to imply that stocks with cheaper valuations, "value" stocks, cannot grow. And that companies that are expensive on the stock market necessarily exhibit positive and high growth. The reality, however, is that there are a lot of companies on the stock market that are relatively cheap, but also exhibit nice and profitable growth.

One way to detect those companies is to select those that put down a high return on their used capital. A high return implies by definition that only profitable companies are selected. Startups and companies with great plans but that still have everything to prove are then avoided.

The second part of that ratio is also important: a high return on capital employed, Return On Capital Employed (ROCE), implies that the capital employed remains limited. Companies that need a lot of additional investment to grow are also excluded in this way. Unless there is a correspondingly high fee in return.  

Consequently, stocks with high ROCE have historically scored better returns. This can be clearly seen if we once again split the stocks from the S&P500 into 2 groups: this time we look at those with a higher versus lower than average ROCE. The chart below illustrates the results.

In addition, we believe that an investor should never become blind to the price paid. If price, the valuation of the stock, is taken into account in addition to quality, it would have historically produced even higher returns. In the chart below, we also split the segment that falls under "high quality" among themselves into stocks with low P/E and price-to-book ratios, versus stocks that quote more expensively according to these ratios. This would have further jacked up returns historically and continued to work in the more recent past.

So it seems a logical conclusion: the better returns could be achieved through a diversified portfolio of stocks of companies generating high returns on their capital employed, focusing within that category on those quoting at acceptable to cheap valuations.  

Will these criteria continue to stand the test of time? Only the future can tell....

At Value Square, we do not believe in the existence of a crystal ball. Returns from backtests and from the past are never a guarantee of future returns. For more information about this study or strategy, feel free to contact Value Square.

References

[1] Fama, E. F.; French, K. R. (1993). "Common risk factors in the returns on stocks and bonds". Journal of Financial Economics.

[2] The European small caps index has only existed since the end of December 2000. This was therefore taken as a starting point in the analysis of the European indices.

[3] Alphabet, Amazon, Apple, Meta, Microsoft,Nvidia and Tesla