Beyond the Mega-Caps: Why Small-Cap Stocks Still Matter
Don't miss out the future winners.
If you’ve been watching the markets lately, you’ve may noticed that the big names are stealing the show. From tech giants to future AI market entrants, large-cap companies have dominated headlines and portfolios.
But in the rush to chase the winners of yesterday, are we ignoring the potential winners of tomorrow?
Including small-cap stocks in a well-balanced portfolio is a strategy worth considering. The rationale for including them center around three key ideas: growth potential, diversification, and historical value.
1. The Growth Engine
The most obvious reason to look at small caps is growth potential. Large-cap companies are often mature beasts; they’re stable, they pay dividends, and they’re less likely to rock the boat. Small-cap firms, on the other hand, are usually in the early stages of their lifecycle. They have high potential to grow their revenue and market share.
To emphasise the point: all the massive companies we know today started small. Some survived to become giants, and those survivors are a major factor in overall market returns. The failure rate is higher among smaller entities, but we can’t predict with certainty which ones will survive or thrive. By having exposure to the small-cap space, you ensure you don’t miss out on the next big thing.
2. Diversification That Works
Small caps aren’t just about growth; they’re about balance. They represent a meaningful chunk of the global market (around 10% of the US market by capitalisation), so are an important piece of the overall puzzle.
More importantly, small caps often behave differently than large caps. They are influenced by different economic drivers, often reflecting the domestic health of their home country rather than global supply chains. This means they don’t always move in lockstep with the rest of your portfolio. Adding an asset class that dances to its own tune can reduce overall volatility and smooth out your returns, even if small caps themselves can be volatile.
3. The Size Premium
There’s a concept in investing called the “size premium.” Simply put, it suggests that small-cap stocks have historically outperformed large-cap stocks over long periods. Models like Fama-French argue that size is a distinct source of risk and return.
When you invest in small caps, you’re accepting higher risk for the chance of higher reward. Over the past century, small caps have rewarded that risk. They outperformed large caps by roughly 1.5 percentage points annually.
However, this isn’t a straight line up. There are periods of underperformance, which means PATIENCE is a crucial behaviour for any investor in this space.
What About Recent Performance?
If small caps are so compelling, why have large caps been winning recently?
Many analysts point to a “new normal.” For example, the rise of private equity means fewer Initial Public Offerings (IPOs), and those that do happen often come to market later in their growth journey. There are also concerns about deteriorating financials in the small-cap space. To be honest, these concerns aren’t unfounded but they mostly apply to a specific subset: stocks with high valuations and low profitability.
You don’t need an economics degree to know that high prices and low profits don’t mix well. The good news is you can simply exclude those troublesome companies from your portfolio.
Despite the noise, small caps have stayed in line with their long-term averages, delivering 11.6% per annum over the past three years and 11.9% per annum since 1927. It’s actually the large caps that are bucking historical trends, with S&P 500 returns over the last three years being nearly double their long-term average.
Betting on a continuation of that outperformance requires expecting further unexpected success stories. Is that a reliable bet?
The Valuation Argument
If you’re worried about overexposure to the currently high-priced US market, small caps offer compelling value.
Large Caps: P/E multiple has grown to more than 30x.
Small Caps: P/E ratio sits at just 16.4x.
That represents significantly better value for the patient investor.
Avoiding Concentration Risk
Finally, there’s the issue of concentration. Large-cap indices are heavily weighted toward a small number of mega-cap companies. The “Magnificent Seven” now account for more than 35% of the S&P 500’s weight. Diversifying into small caps helps lessen your exposure to these top-heavy stocks.
The Bottom Line
The largest and most successful companies of today were all small caps once. Their journey from small to mid to large is a vital contributor to overall market returns, and it’s too important to ignore.
Whilst small caps have underperformed larger companies recently, the performance is relative. They’ve performed in line with historical norms, and the migration of companies from small to mid-cap has remained steady (roughly 11% over the last 10 years).
A broadly diversified allocation to the small-cap market can help long-term investors capture future winners and take advantage now of the biggest companies of tomorrow.