Have Patience With Small-Cap Stocks



It has not been a good year for small-cap stocks. As of yesterday’s close, the Russell 2000 index was down 4.78% year-to-date. In contrast, the larger-cap Russell 1000 index was up 7.72%. We’re seeing similar comparisons with other indexes as well. For example, the S&P SmallCap 600 was down 4.99%, whereas the S&P 500 index was up 6.52%. (Obviously, these numbers will be lower once data reflecting today’s decline is published.)

Valuations have been blamed as the reason why. Small-cap stocks were expensive relative to large-cap stocks. They still are. S&P Capital IQ calculates the SmallCap 600 as trading at 22.1 times trailing 12-month (TTM) earnings, versus 26.3 at the end of 2013. In contrast, the S&P 500 is trading at 16.8 times TTM earnings, versus 16.9 at the end of 2013. Arguably, in the background, other concerns (e.g., the tapering of bond purchases by the Federal Reserve, geopolitics, the length of the bull market, etc.) are also playing a role in causing small caps to lag.

This is not the first time small-cap stocks have underperformed large-cap stocks, and it likely won’t be the last time either. As John McDermott and Dana D’Auria discussed a few months ago in the AAII Journal, small-cap stocks only beat large-cap stocks on an annual basis about 50% of the time between 1926 and December 2013. The size premium realized by small-cap stocks comes from their higher volatility. Small-company stocks experienced a standard deviation of 32.3% between 1926 and 2013. Large-company stocks had a lower standard deviation of 20.2%, according to the 2014 Ibbotson SBBI Classic Yearbook. (Standard deviation measures the range of values above and below average for a set of data. Larger values indicate greater variability.)

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