Since the fallout of the financial crisis, the largest companies listed on U.S. markets have provided the best returns. The likes of Facebook, Inc. (FB, Financial), Apple Inc. (AAPL, Financial) and Netflix Inc. (NFLX, Financial) were the drivers of the bull market that lasted a decade. There’s no denying that these companies have grown their earnings in leaps and bounds in this period, resulting in their stellar market performance.
Amid the chaos in global capital markets, the five largest companies representing the S&P 500 index have continued to establish their dominance. As illustrated below, the market capitalization of these companies now accounts for more than 20% of the index, which is a 40-year high.
Source: The New York Times
American markets have gained some lost ground since March 23, and these companies have been the winners once again. Commenting about this phenomenon, Thomas Philippon, a finance professor at the New York University, told the New York Times:
“The firms that were the top dogs going into the crisis also happen to have the most resilient business models because they can do everything online. It turns out Amazon was one of the most successful businesses in the U.S., and on top of it, they are the ones who can keep processing orders.”
As evident from this statement, there’s a lot to like about these large-cap companies. However, investors are ignoring an important signal related to the performance of small-cap stocks.
Small-cap returns have been lackluster
Riskier assets should provide better returns than relatively less risky assets. This is one of the most basic economic theories. Investing in small, high-growth companies is inherently riskier than buying shares of well-established companies. Therefore, investors seek for additional returns as compensation for taking this risk. However, things did not play out well for such investors in the last few years.
| Index | Price return in the last 5 years |
| S&P 500 | 35.3% |
| Russell 2000 | 3.07% |
Source: Eikon
This disappointing performance has pushed many investors away from this lucrative asset class. In the context of investing, five years is not necessarily a long enough time horizon to evaluate the attractiveness of a certain investment vehicle. If the timeline is extended to include data from 1980, small-cap stocks (represented by the Russell 2000 index) emerge as the winner.
| Index | Price return since 1980 |
| S&P 500 | 2840% |
| Russell 2000 | 3130% |
Source: Eikon
This long-term outperformance of small company returns is testimony to the attractive opportunities an investor can find in this space.
A deeper dive into the historical returns
Contrary to the belief of many investors, empirical evidence points out that a recession might turn the tables in favor of the Russell 2000 index. FTSE Russell researched in 2014 to analyze small-cap returns in the context of economic peaks and troughs. Surprisingly, this study found that a small-cap premium emerges three months before an economic peak and continues to be a feature of markets through 12 months from the peak.
Source: FTSE Russell
Following the expansion that lasted more than a decade since the fallout of the financial crisis, it’s reasonable to assume that the American economy has now peaked. Going by the above data, small-cap returns might provide stellar returns in the coming months.
There are more reasons to be hopeful of this asset class. According to data from Royce Invest, whenever the Russell 2000 index provided a negative return in a five-year period, the following years were spectacular.
Source: Royce Invest
On March 31, the five-year annualized return of the index fell below zero. This could be an early indication of stellar returns from the index in the coming years.
Based on these two sets of empirical evidence, I conclude that small-cap stocks are well-positioned to outperform their large-cap peers in the next few years.
Will history repeat this time?
Navigating the current market situation could be more difficult compared to recent economic recessions. The most recent recessions before this one triggered as a result of the failure of only a single business sector. It was the tech sector when the dotcom bubble crashed and the financial services sector in 2008.
However, the current economic downturn is different in that every industry has been affected from the very beginning of the crisis, which has made it difficult for the government to intervene and bail out the troubled companies.
For example, in 2008, the banking sector received the biggest support from regulators as the industry went to the brink of collapse. This time around, companies representing almost all the business sectors are seeking federal aid, which is an adverse outcome as this significantly limits the power of stimulus packages. Billion-dollar aid packages have been introduced to help small businesses as well, but the benefits will not flow to each company that is struggling. Regardless of the size of a company, investors need to be very diligent when selecting a company to invest in.
During these troubled times, small companies have one particular advantage; most of these businesses do not depend on suppliers or buyers outside of the country to generate the bulk of revenue. Global trade has grown in leaps and bounds over the last decades, and many large companies such as Apple and Netflix generate a significant portion of their inventory and revenue outside the U.S. This makes these companies vulnerable to both supply and demand-side shocks resulting from adverse economic conditions in countries they depend on. Small businesses, however, primarily operate within the borders of thier countries, which makes it possible to return to their normal state once mobility restrictions are lifted.
Second, smaller companies have an unparalleled advantage to monitor the health of all of their employees closely, enabling them to identify potential Covid-19 patients early. This will help them avoid factory and store closures. However, things are entirely different for a larger company as keeping a tab on all their employees is not practical. Because of this reason, small companies will be fully functional before many of their larger peers, which should help these players to cap the negative impact on revenue at a manageable level.
On the other hand, the state government will likely come up with a set of guidelines that should be followed by each company once the economy reopens. For large companies, adapting to these measures will be difficult at first because of their sheer scale, whereas things will be easier for companies with a limited headcount, as this brings them more flexibility. These are some of the important factors left out by many analysts and investors when projecting future returns from equity markets.
Takeaway: look beyond the noise to find attractive opportunities
There is a lot of noise in the market. The majority of investors are looking up to the largest companies in the U.S. to deliver stellar investment returns.
However, the less-talked-about small companies have structural advantages over these large companies to generate very attractive returns in the coming years. The recession could be a catalyst for small-cap stocks to outperform the broad market, the same way it has done every time the economy peaked.
Having said that, investors still need to be very cautious about what they invest in. Even though investing in an exchange-traded fund that focuses on small-cap stocks seems to be the easiest way to gain exposure to this segment, the macroeconomic set-up does not support such a decision. Active investing strategies can be used to dig deep into the financials of a company to identify winning bets.
Disclosure: I do not own any stocks mentioned in this article.
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