Gustave, I agree that small caps have underperformed large caps by a small margin.
I'm afraid the margin's been wide... Here's the whole story:
BusinessWeek / March 1, 1999
Finance
BIG CAPS, BIG EDGE
Virtually every foreseeable trend favors large companies
For four years in a row, Wall Street pundits have resolutely made the same New Year's prediction: Small-cap stocks will outperform blue chips over the coming 12 months. Each time, they have been wrong, but that hasn't stopped them from making the same forecast again this year. Their argument is simple: Small caps have lagged behind the large caps for so long that they have become historically cheap in comparison. And, they say, such disparities in valuations usually don't last very long.
But the small-cap bulls may be sorely disappointed. Investors have latched on to big stocks since early 1994, and it is not a fad. The powerful economic forces such as disinflation, globalization, and profits growth that made large caps big winners are still firmly in place. ''Sure, the valuation dichotomies are massive, but the world has changed [and] the power of scale has grown increasingly important,'' says Beth F. Terrana, portfolio manager of the $11 billion Fidelity Fund, who has 86% of the fund's assets in large-cap stocks.
POOR START. For investors in small caps, the last five years have been frustrating. They made money, but nowhere near what they could have made by investing in large-cap stocks (chart). In 1994, the Russel 2000, a widely followed index of small-cap stocks, trailed the large-cap-dominated Stantard & Poor's 500-stock index by about three percentage points, a lag that kicked off the recent era of underachievement. Last year, that performance gap was a yawning 31 percentage points--and the results so far this year are not encouraging. For the first seven weeks of 1999, the Russel was down 7.7% while the S&P was flat.
Are the small caps just going through a prolonged down cycle? After all, they trounced big stocks in the early 1990s. For some seven decades, small-cap stocks earned a 12.4% average annual return, vs. 11.2% for large caps, according to Ibbotson Associates in Chicago. And the law of numbers suggests that small caps could offer investors far more growth potential than companies that have already grown quite large.
That's theory. The facts, at least those of the last few years, show that big is beautiful. In 1998, for instance, the largest 25 stocks in the S&P 500 accounted for 63% of the index's 28.6% gain and the 100 largest accounted for 99%. It hasn't hurt that in each of the last three years, economists have forecast slower growth for the economy. So investors continued to buy the stock of the bigger, more established companies and to shun the scrappier and ever-cheaper small caps.[...]
The big boys are also the biggest beneficiaries of low inflation. In an economy where companies have little or no pricing power, these world-class players have greater ability to control costs than small companies. For example, larger companies can more easily strong-arm suppliers into lowering prices, while smaller customers may have too little clout with the suppliers to lean on them hard. That's not all. ''Small companies,'' says Thomas M. McManus, a portfolio strategist at NationsBanc Montgomery Securities LLC, ''often lack the pricing power they need to boost revenues.''
A lack of pricing power would obviously hurt small caps if the economy were to slow down. And if the economy were to go into recession, small caps would take an even nastier hit than the big stocks. However, coming out of recession, the small stocks tend to outperform the bigger companies, says Roger G. Ibbotson, chairman of the investment research firm that bears his name. Indeed, in 1991, the Russel 2000 surged 46%, leaving the S&P 500, which gained only 30.5%, in the dust.
The large-cap stocks are also being propelled by momentum in the stock market. Watching the success of the S&P 500, investors are flocking to S&P index funds, pushing billions of dollars into the same large-cap winners. The cash flowing into mutual funds that hold stakes in small companies, by contrast, fell 74% last year from the level of 1997, according to Financial Research Corp. Some large investment firms have also pulled back from small caps. Fidelity Investments, for example, has just seven of its 153 domestic-equity fund managers and analysts following small caps on a full-time basis.
Another reason that institutional investors are shying away from small caps has to do with problems executing trades on the NASDAQ market, where most of the small companies trade. Lee Kopp, president of small-cap specialist Kopp Investment Advisors Inc. in Edina, Minn., says that NASDAQ market reforms in recent years have resulted in fewer firms making markets in small-cap stocks.[...]
Eventually, small-cap stocks may get their due. Right now, however, economic and market conditions clearly favor the large companies. Investors who have piled into large-cap stocks or mutual funds that own them will continue do a lot better than those who pin their hopes on the small fry.
By Geoffrey Smith in Boston |
