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Investing in large or small stocks?
In this article, we'll take a closer look at the share class specifically. The question then quickly becomes: which type of stocks are “the best”?
Small or large companies?
A classic discussion is whether it is better to invest in stocks of small companies (“small caps”) or large companies (“large caps”)? The classic literature assumes that small company stocks are generally slightly better: Fama & French already published their world-renowned article in 1993 that shows that small cap stocks of smaller companies perform slightly better than large caps over the long term.
An analysis of the European market over the period 2000-2024 confirms these findings. We see that small companies in Europe performed significantly better than the large cap index over the entire period. The European Small Cap Index achieved an annual return of 7.44% compared to 3.90% for the wider MSCI Europe. If we look at more recent (2016-2024) data, we need to nuance this picture a bit. The flow of money into large market capitalizations has been clearly visible since 2016 and accelerated in the post-corona era, raising returns for large listed companies above that of the small ones.
If we look at the United States, we see the same trend, but much more accentuated compared to Europe as a result of the extremely strong stock market momentum in 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 US stock market index that includes the 500 largest companies, was able to return 7.48% annually over that period. At the Russell 2000, an index of 2000 small and medium-sized US companies, the return over the same period was 7.43%.
However, this conceals major interim differences. Until the end of 2016, the mantra was “Small is Beautiful”. The Russell 2000 achieved a return of 7.39% per year over that period, while the S&P500 had to make do with 4.51%. Since then, however, it has been the largest companies that are making the nice weather. From 2017 to now, the S&P500 has achieved an average annual return of no less than 14.28%. The return of the smaller companies was orphaned at 7.51%. Although that return was almost perfectly in line with his average return over the longer term.
Three reasons can be cited as an explanation for this...
- The major technology stocks have made phenomenal returns in recent years. Helped, among other things, by covid and, more recently, by the technological breakthroughs in artificial intelligence. The recent stock market performance of the “magnificent seven”, the 7 largest US technology stocks, therefore drew almost the full return of the stock market index. Not that technology is absent from small companies: it's the 4th largest sector in the Russell 2000, weighing 13.6%. But partly due to the high flight of 'the seven', the technology weight at the S&P500 has now risen to as much as 29.8%.
- The US regional banks have had a hard time in recent years. Providing long-term loans and financing it with short-term deposits had to come when interest rates started their steep rise. And those regional banks are mainly included in the small cap indices.
- The Russell 2000 also has a stronger real estate weighting. Here, too, a combination of covid and rising interest rates meant that both the office market and shopping centers were hit particularly hard.
This meant that the performance of small cap indices lagged behind that of large caps. Which in turn causes a boost: rising indices attract new investors, creating positive momentum and also further increasing valuations. What does the future hold? We can only see 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 historic limits. Where 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 observation in the academic study by Fama & French is that, on average, “cheap” stocks perform better than “expensive” stocks. This is often translated to 'value' versus 'growth'. Where value, i.e. cheap stocks, have historically fared slightly better in the long term.
At Value Square, however, we think the division of stocks into “value” versus “growth” is a bit poorly chosen. The naming seems to imply that stocks with a cheaper valuation, “value” stocks, cannot grow. And that companies that are expensive on the stock market by definition show positive and high growth. The reality, however, is that there are many companies on the stock market that are relatively cheap, but also achieve good and profitable growth.
You can detect these companies, among other things, by selecting companies that offer a high return on their used capital. By definition, a high return implies that only profitable companies are selected. Startups and companies with big plans, but which still have everything to prove, are then avoided.
The second part of that ratio is also important: a high return on the capital used, Return On Capital Employed (ROCE), implies that the capital used remains limited. In this way, companies that need a lot of extra investments in order to grow are also excluded. Unless there is a correspondingly high fee in return.
Stocks with a high ROCE therefore scored better returns historically. This is clearly seen when we split the S&P500 stocks into 2 groups again: this time we look at those with a higher versus lower than average ROCE. The graph below illustrates the results.
In addition, we believe that an investor should never be blind to the price paid. If, in addition to quality, the price, the valuation of the stock, are also taken into account, this would have historically resulted in even higher returns. In the graph below, we also split the segment that falls under “high quality” into stocks with a low price/earnings ratio and price/book value, versus stocks that are more expensive according to these ratios. This would have historically boosted returns even further and continued to work in the more recent past.
It therefore seems a logical conclusion: the better returns were achieved through a diversified portfolio of stocks in companies that generate a high return on their used capital and where, within that category, the focus is on those that are trading at acceptable to cheap valuations.
Will these criteria stand the test of time? Only the future can tell...
At Value Square, we don't believe in the existence of a crystal ball. Returns from back tests and the past are never a guarantee of future returns. For more information about this study or strategy, you can of course 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 been around since the end of December 2000, and this was therefore used as a starting point for the analysis of the European indices.
[3] Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla
