Over the past decade, large-cap stocks have significantly outperformed other market segments, leading to an unprecedented valuation disparity between large and small companies. This phenomenon has created a unique investment landscape, where small-cap stocks, especially those demonstrating consistent profitability, are positioned for a potential resurgence.
Unlocking the Next Market Cycle: Embrace the Power of Small-Cap Growth
The Decade of Dominance: Large-Cap Stocks and the Shifting Tides
For the last ten years, the stock market has been a boon for investors, with the S&P 500 index delivering over a 300% total return and the tech-heavy Nasdaq Composite climbing even higher, exceeding 400%. However, this robust performance hasn't been uniform. The largest corporations have expanded their influence, leaving smaller enterprises trailing. This is evident not only in the S&P 500's record-breaking concentration but also in the subpar performance of small- and mid-cap stocks. Indices such as the Russell 2000 and S&P 600 have seen more modest gains of 142% and 155% respectively during the same timeframe.
A Historic Reversal: The Small-Cap Comeback Story
This prolonged underperformance of small-cap stocks may now be creating an extraordinary investment chance. Historically, small-cap stocks have shown a tendency to surpass large-cap stocks, though their performance is markedly cyclical, with cycles ranging from five to sixteen years. Current indicators suggest that the period of underperformance might be nearing its end, signaling a potential shift where small-cap stocks could lead the market in the coming years. Furthermore, incorporating a specific filter into stock selection can significantly enhance investment returns.
The Underperformance Anomaly and Cyclical Patterns
In the past decade, the Russell 2000 index has lagged the S&P 500 by an average annual return of 5.8%, marking one of the most substantial annualized 10-year return disparities on record for small-cap stocks. Research by Distillate Capital, analyzing stock returns since 1935, reveals that such a significant differential has rarely persisted without an eventual reversal, often leading to multi-year periods of substantial outperformance for smaller companies. A notable precedent occurred around the peak of the dot-com bubble, where small-cap stocks demonstrated remarkable resilience even as large-cap stocks faced severe declines.
Beyond Trend Reversals: The Compelling Value Proposition of Small-Caps
While the cyclical nature of market performance offers a strong case for small-cap investments, there's an even more compelling factor at play: the current market valuation. The S&P 500, with a forward price-to-earnings (P/E) ratio of 22.2, is considered historically expensive. In stark contrast, profitable small-cap stocks, particularly those included in the S&P 600, offer exceptional value, with a P/E ratio of just 15.7 times forward earnings. This valuation gap, where the S&P 600's valuation is 0.7 times that of the S&P 500, mirrors conditions last seen in 1999, which marked a previous trough in the performance cycle for small and mid-cap stocks.
Strategic Investment: Focusing on Quality and Profitability
It's crucial to distinguish between the broader Russell 2000 and the S&P 600. The Russell 2000's valuation premium has grown considerably since 2020, highlighting the importance of selecting high-quality small-cap stocks. The S&P 600's requirement for consistent profitability based on GAAP principles has historically led to its superior performance over the Russell 2000. Research suggests that positive free cash flow is another robust indicator for identifying promising small and mid-cap stocks. Investors can capitalize on the current market environment by focusing on small-cap stocks with consistent profits or positive free cash flow. The Avantis U.S. Small Cap Value ETF (AVUV) stands out as a strong option, utilizing selection criteria that prioritize a company's cash flow to book value ratio, ensuring a portfolio of high-quality small-cap enterprises.
The Expense Ratio and Long-Term Value
While the Avantis U.S. Small Cap Value ETF carries a slightly higher expense ratio of 0.25%, the enhanced performance of quality small-caps can justify this cost. Investors seeking a strictly indexed approach may consider ETFs tracking the S&P 600, though they should be mindful of potential tracking errors due to the lower liquidity of smaller stocks. Regardless of the chosen path, the current landscape presents a significant opportunity within the small-cap stock market, offering a compelling outlook for long-term investors.
