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Small Cap Stocks: Will they continue to outperform?

By: Richard Feldman

By: Richard Feldman, CFP, AIF, MBA

If individuals could forecast which asset class performed best in any given year than there would be untold riches to be had. The problem is that it is extremely difficult to diagnose in any given year where to place your capital. In looking at small cap stocks versus large cap stocks the answer has been decidedly small cap. Large cap stocks outperformed small cap stocks for the first time since 1998 but only marginally. Large cap stocks as measured by the S&P 500 returned 4.89% in 2005 versus 4.56% for small cap stocks as measured by the Russell 2000®. This marginal out performance broke a string of six straight years of out performance by small cap stocks. There has been a lot of speculation that a mean reversion will occur and that large cap stocks will outperform small cap stocks in 2006. Year to date small cap stocks have significantly outperformed large cap stocks. However we are only in February so there is still a long race to December 31st and the eventual winner for 2006.

Russell 2000

The Russell 2000 is one of 21 U.S. equity Russell Indexes and is used to measure the performance of small capitalization equities or small cap stocks. The Russell 2000 is made up of the 2000 smallest companies in Russell’s main index which is the Russell 3000. The Russell 3000 is a broad based index that represents approximately 98% of the value of the investable U.S. equity market. The index leaves out the tiny micro cap segment which makes up the remaining 2%. The Russell 2000 makes up only about 8% of the total market capitalization of the Russell 3000. According to the Russell website, the average market capitalization for a stock in the Russell 2000 is 1 Billion dollars and the Median Market cap is 561 million. The largest stock in the index is 3.6 billion which pales in comparison to the average market capitalization of a stock in the S&P 500 which is 92 Billion.

Small Cap Stock Performance:

The Russell 2000 over the past six years has had an 8.28% annualized rate of return versus 1.77% for the S&P 500 significantly outpacing large cap stocks. To follow are the results for the past six years:

Year Russell 2000 S&P 500
Index Index
1999 21.26 21.03
2000 -3.03 -9.1
2001 2.49 -11.88
2002 -20.48 -22.11
2003 47.25 28.69
2004 18.32 10.87
2005 4.89 4.56

Since 1979 small cap stocks as measured by the Russell 2000 index and large cap stocks as measured by the S&P 500 have had similar performance.

Statistics Summary

Jan 1979 – Dec 2005

S&P 500 Russell 2000
ANNUAL DATA:
Average Return 14.5 14.65
Standard Deviation 15.82 18.81
Total Return 2868 2687

Historically small cap stocks have tended to lead or lag those of large companies for periods of several years and have tended to perform the best when the economy is beginning to recover from a recession.

As you can see from the chart above small cap stocks as measured by the Russell 2000 have significantly outperformed the S&P 500 in 2003 and 2004 but lagged the S&P 500 in the late 1990s.

Summary

So which asset class will lead the market in 2006? The answer to the question is I don’t know. It is the same answer I gave last year around this time. The market is cyclical in nature and at some point market leadership will swing back to large cap equities. What I do know is the following:

  • Research has shown that small cap stocks while having higher volatility have historically earned higher returns than larger companies; although past performance is no guarantee of future performance. This excess return has been deemed the “small cap premium” meaning that investors are rewarded for higher risk.
  • Because their prices often move independently of those of large companies, small capitalization stocks can help diversify a portfolio leading to higher portfolio returns and lower volatility.

It is hard to know when the small cap premium will show up. As I mentioned before small cap stocks have had long periods of time when they have either outperformed or under performed large cap stocks. For instance the total return of the Russell 2000 from 1999 through 2005 was 74.57%. The total return of the S&P 500 over that same time period was 13.06%. Conversely in the late 1990s small cap stocks underperformed large cap stocks significantly, it was hard to get anyone to even mention small cap stocks as an asset class. But we already know how that story turned out. Over a long term investment horizon allocating a portion of your portfolio to small cap stocks will lead to higher returns and lower volatility at the portfolio level. That is the great thing about modern portfolio theory you don’t have to be right every year. You just have to allocate your resources efficiently.