SPY has outperformed IWM by 50%

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31

Chaim -
I have come up with an explanation for why small caps have massively underperformed large caps over the last ten years, but it’s not a great one because if it were true small caps should have underperformed large caps in the 2002 to 2008 period as well, and they didn’t. I still maintain that small caps are not as good a value as large caps; you disagree. I’m grateful to you for the charts of unprofitable companies too. Here’s my question for you: do you have an alternative explanation for why small caps have underperformed large caps over the last ten years?

  • Yuval
32

[quote]
Chaim -
I have come up with an explanation for why small caps have massively underperformed large caps over the last ten years, but it’s not a great one because if it were true small caps should have underperformed large caps in the 2002 to 2008 period as well, and they didn’t. I still maintain that small caps are not as good a value as large caps; you disagree. I’m grateful to you for the charts of unprofitable companies too. Here’s my question for you: do you have an alternative explanation for why small caps have underperformed large caps over the last ten years?

  • Yuval
    [/quote]Yes. Not only do I have a theory, but back in 2012 I wrote that I was almost certain that it was going to happen. And my prediction came true. You won’t find me making lots of predictions like that. You also won’t find me saying too often that I am almost certain about stuff in the markets.

I written about my reasoning on this forum a few times.

Basically, there has been a pattern over numerous market cycles that large growth (and by extension the S&P 500) does better at the end of a long bull market. This is observation that has held out of sample for at least two market cycles. This was somewhat of a proof, albeit not a reason.

Furthermore, prices of high quality large cap stocks (such as Google) were trading at PE multiples similar to small caps. Fundamentally, that made no sense. Why should better businesses trade at the same PE as low quality stocks?

At the same time, small caps were almost all fully valued (or close to it). To illustrate, as a financial analyst, collecting value investment ideas from multiple great investors, I had kept a watchlist of stocks that were trading at 1/2 price. I had twenty or more stocks on this list at all times from 2007-2011. But by 2012 I was not finding any stocks trading at half price. This meant that the party was over for small value. As you yourself have observed in the past, small value stocks are not long term holdings. You buy them for the pop and then trade them. But there was no pop left. The juice had been squeezed.

From a behavioral standpoint, I understood that investors were once again fighting the last battle. They remembered vividly that large caps (such as AIG and banks) had failed spectacularly in the GFC. So they did not view large caps as safe. They also remembered the lessons from the dot com crash; to stay away from tech stocks. After all, Microsoft had not gone up in ten years. (What they didn’t realize was that Microsoft had been selling at highly inflated valuations in 2000, and it took ten years or so to grow into its valuations).

But I understood then that eventually the tide was going to turn. I didn’t know when. (Ultimately it took a couple more years for large growth to gather steam and it’s momentum has accelerated).

At this point, investors have again forgotten the hard earned lessons from the 1920’s, 1960’s, 1980’s Japan, and 1990’s; price ultimately matters. Stocks will revert to track earnings. So everyone “knows” that there is no point in owning small value stocks. Proof? The past ten years. FAANG and tech stocks are the place to be. The current attitude is: What is discounted cash flow? Is that something like the failed modern portfolio theory? Hasn’t the recent past dis-proven DCF?

It’s as Templeton said: “Bull markets are born on pessimism, grown on skepticism, mature on optimism, and die on euphoria” I’d guess that this is what he meant by euphoria. “Price? Why does price matter? Buy great companies!”

Right now I am not predicting small value outperformance (although it wouldn’t surprise me). But I would be surprised if small caps will not bounce back faster from the bottom of this bear market, whenever that bottom is going to be.

P.S. Small growth (SG) stocks are often fundamentally different than large growth (LG). A typical SG stock typically has no profits; just a dream. Why would anyone buy those? OTOH, large growth typically is dominated by stocks with an accepted business model and growing rapidly. Those stocks may be great businesses. So biggest argument against them is price. Prices often match or exceed all reasonable expectations for future cash earnings. When that happens risk is highest.

So, in summary, large caps are risky now mostly because of valuations (a reason) and because of the crash (a possible catalyst). Small caps are risky now because of the recession (a reason and a catalyst). In fact, small caps overall are more vulnerable than large caps. So I am still very conservatively positioned. But as usual I am not close to being certain about the near term, in fact, I am not certain about the next ten years either.

33

Chaim -
What you write about is why large growth has outperformed small value. There are all sorts of definitions of growth and value. But what can’t be denied is that large caps have outperformed small caps, growth/value be damned. A lot of small caps are essentially growth stocks. A lot of large caps are essentially value stocks. So if growth is outperforming value, that shouldn’t necessarily mean that large caps are outperforming small caps. Especially if, by at least some metrics, small caps have HIGHER p/e’s than large caps.

I guess my theory is quite different. Small caps used to outperform because they were natural draws for speculative investors. All the innovation was happening in the small-cap space. But with the explosion in venture capital and the fact that large caps are leading high-profile innovations, that’s no longer the case. Couple that with the fact that small caps are poor earners and you’ve got a good recipe for failure. What will it take to turn that around? If venture capital implodes and we get more IPOs, that will help.

We can disagree, but the conversation has been fascinating. Thanks.

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Experienced market veterans have claimed for decades that it’s large growth vs small value. They also predicted that investors would stop caring about price and favor large growth at this stage of the market cycle. Did these predictions come true? Here is a chart.

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Yes, this type of theory becomes quite popular at the end of market cycles. It’s fascinating how history repeats itself. A similar theory was popular in the late 1990’s. Forget small value, they said. All the innovation is in large growth, they said. AOL, Amazon, Microsoft, Yahoo. Names we still remember. Pets.com, TheGlobe.com? They were not small caps.

Studies of IPOs have shown years ago that the largest IPOs (by market cap) do the best. This indicates that disruptive innovations are made by large companies.

Your theory will work–until it doesn’t. I predict another 2000-2005 period starting within the next five years where small value is going to really really outperform. Why? Because valuations matter for large growth, small value, and everything in between. But many investors are forgetting that.

36

I think the obvious problem is say a large growth has a P/E of 30, in 5 years it will be a P/E of 10 at today’s prices.
A small value has a P/E of 5 , in 5 years it will be out of business or have earnings much lower than today. Value stocks for the most part have declining earnings since 2017.

Most value stocks, dare I say, are not that cheap.
Not many stocks pay a dividend of more than 10% (that’s not going to be cut immediately), that is also not having declining earnings.
Even if you get a 10% yield, after tax it’s like 8% yield. Not worth the risk if the earnings decline.

For the most part, if a company just maintains 0% growth forever, they will have declining earnings. Because labor and cogs cost inflation is 2% a year. You basically need to grow or you will die eventually one day.

37

Well, I really really hope you’re right and I’m wrong. That would be fantastic.

And, by the way, I’m still sticking with underpriced microcaps, despite my pessimism.

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[quote]
I think the obvious problem is say a large growth has a P/E of 30, in 5 years it will be a P/E of 10 at today’s prices.
[/quote]True. When Google was trading at a PE of 15, I was very tempted to buy it. I knew at the time that large growth was set to outperform. But that’s not my game. I was hoping to make more in small caps, and I did. Until mid 2018. But Google is a rare stock. Most fast growers mean revert and underperform expectations.

[quote]
A small value has a P/E of 5 , in 5 years it will be out of business or have earnings much lower than today.
[/quote]Is that really true? It depends on the stock. Mean reversion tells us that today’s slow growing stocks will be stronger tomorrow. (With the caveat that this only applies to profitable stocks).

As a group? Probably. But I am looking for the exceptions. Besides, could it be that value stocks as a group have declined in earnings because the profitable stocks have been bought out? If that is the case, then the decline in earnings does not tell us about the remaining good ones.

[quote]
Most value stocks, dare I say, are not that cheap.
Not many stocks pay a dividend of more than 10% (that’s not going to be cut immediately), that is also not having declining earnings.
Even if you get a 10% yield, after tax it’s like 8% yield. Not worth the risk if the earnings decline.
[/quote]Whatever is not cheap is by definition not a good value. That’s why I have never in vested in the value index. [EDIT: I don’t agree with the way indexes define value, I think I can do better with P123.] All you need is to find a small basket of [truly] very cheap stocks and you are good to go.

[quote]
For the most part, if a company just maintains 0% growth forever, they will have declining earnings. Because labor and cogs cost inflation is 2% a year. You basically need to grow or you will die eventually one day.
[/quote]Right, you need to grow profits about as fast as inflation just to keep from shrinking earnings. But investment growth does not solely depend on earnings growth. Your hypothetical stock should grow as fast as its earnings yield. If you a buy a stock with 2% growth at a P/(owner earnings) of less than 10, you will have very good results. Your growth is 12%+ a year without P/E expansion and you have a free option on P/E expansion (or a buyout). Some of those options will be exercised.

Just to be clear: I am not calling a bottom here yet in small value. I don’t yet know when the bottom will be. But the longer the party lasts for large growth, the bigger the party will be for small value when it’s turn comes.

Business quality and/or growth by itself is not enough of an argument in favor of buying large growth. It’s just the human brain trying to pin a reason on the recent outperformance of large growth. I think that growth/quality has been part of the reason, but the primary reason has been the value of large growth stocks. Yes, large growth stocks were actually an incredibly good value back in 2012 or so. Not because of cheap PEs but because of cheap price to future earnings. Since then large growth has benefited from growth, PE expansion, profit margin expansion, and now safety (since large companies are more likely to survive this recession). My impression is that the news has not yet been priced into the markets, partially because of massive direct government buying. I am not making a prediction as to the timing, but small value will once again have its day in the sun, despite all the arguments now favoring large growth as an asset class.

That said, if I had a reliable system to use for investing in large growth I would have done so a year ago. I don’t. So am being defensive while waiting for the tide to turn.

39

Although I am defending small value, (or at least my version of it), I am not yet pounding the table in favor of small value right now. I do know that it will bounce back one day. I just don’t know exactly when.

My best guess is that small value will bounce the highest off the bottom of this bear market. I don’t know if the outperformance will continue after that after the first nine months to three years. But the longer LG outperforms, the more SV will excel when it gets it’s turn in the sun again.

40

Here is my simple explanation on the subject. It is based on a presentation by John Templeton to a group of us in the early 1990s. Someone asked him what was his strategy. He said it is very simple, the way I got rich was to wait for a recession and then buy every stock under $1 a share. Repeat! When he was most active he said recessions came routinely every four and a half years. I modified his strategy a bit and have used it ever since with amazing success. (Interestingly, this matches some of the conclusions from that article on crisis investing.)

That brings us to the present times. Why have small caps stocks underperformed for a long time? Reason #1) We rarely have recessions anymore! The Fed has tried its best to eliminate them. Reason #2 (a natural outcome of #1): Now, during even the slightest economic softness, the Fed’s policy of zero interest rates and mass stimulation has created zombie (mostly small cap) companies. So, in past recessions, if you had a cheap small company you knew that it was at least a decent company–for it was surviving the recession! (Recessions were a natural cleansing of bad companies–the forest fire analogy.) Now, there are a lot of crappy companies that should have gone bankrupt long ago.

Still, in my opinion, this current recession offers small cap opportunities–but I have modified my base-case strategy (because of reason #2).

41

I have been thinking a lot about what is being debated in this post. My historical beliefs align with what Chaim and Chipper are saying. However, I now believe that the market has structurally changed. I am an Economics major and years ago we learnt about economies of scale and diminishing returns which basically talks about how a company like Ford can become more efficient as they grow larger and spread the fixed costs over increased sales up until a point when the firm becomes too large to manage and they start to realize diminishing returns as the firm expands and has to continually invest more capital to grow the business. Compare that to nowadays with Fang stocks that are fundamentally different. The largest corporations today all benefit from network effects. The marginal cost of Microsoft selling another office 365 product is basically zero. Same for Facebook every new customer they gain is basically at a zero incremental cost. Now add a few more million customers online every year and you start to realize how the global behemoths are kicking the small caps asses. The small cap innovators of today have to pay Google if they want to advertise or give Amazon a cut of their profits if they want to grow their business. Its a totally different cost structure that I never learned about in University. While I do think small caps will have their day I don’t think it is today or tomorrow.

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Small business formation has been dying in the US for a long time and COVID is now causing a mass extinction event:

https://www.theatlantic.com/ideas/archive/2020/05/bridge-post-pandemic-world-already-collapsing/611089/

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MikeC,

Some of the Nifty Fifty were similar. For example, what’s the incremental cost to Coca Cola of selling more syrup? Very low. So, Coca Cola was a FAANG type stock back in the day. It was selling at a very high PE. It eventually grew into that PE, but not before it’s price crashed. If history will rhyme, I wouldn’t be surprised if these huge companies hold up the longest throughout this crash, but eventually crash along with everything else. Then, coming out of the bottom, I expect small value to lead for at least the first 9 months to 3 years. After that we shall see.

David,

Thanks for the article. I have alluded to the problem quite a bit back when people were still thinking that this was a normal market correction and hoping for a V shaped recovery. BTW, most small stocks that were profitable before the shutdown will recover. They are not doing as good as the FAANG stocks but are in much better than the corner barber. OTOH, many small stocks which were not profitable during the good times will be forced to close their doors. Others, especially those which will be shutdown for more than a few months (e.g. travel, entertainment, restaurant, oil) will have a much more difficult time recovering. Cyclical stocks may also be affected more than the typical recession.

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Chipper6 wrote in April 2020:

At this point, investors have again forgotten the hard earned lessons from the 1920's, 1960's, 1980's Japan, and 1990's; price ultimately matters. Stocks will revert to track earnings. So everyone "knows" that there is no point in owning small value stocks. Proof? The past ten years. FAANG and tech stocks are the place to be. The current attitude is: What is discounted cash flow? Is that something like the failed modern portfolio theory? Hasn't the recent past dis-proven DCF?

And:

2021 Update:
Small cap value (top 300 cheapest Russell 2000 stocks as ranked by “Core: Value”) has been up by 151% vs 56% for the Nasdaq 100 (large growth proxy) since that was written. At this point small value is still cheaper than large growth but not by as much. Price has rocketed up and what would have taken years during regular markets took a year (perhaps because of all the stimulus money).

Valuations matter. What’s cheap now? Many international stocks. While we don’t have data for individual international stocks (except Canada), I would love to be able to backtest international ETFs based on Market Cap/GDP and other value measures.

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Complex Subject.
Have a look at backtests from 43macro.

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Regime 1 Goldilocks: ROC GDP up, ROC Inflation Down
Regime 2 Reflation: both up
Regime 3 Inflation: only ROC Inflation up
Regime 4 Deflation: both down.
Random Thoughts:
The only comparison that makes sense is to compare a big cap with a small cap with kind of the same fundamentals, factors (growth momentum, industry momentum, value etc.)
Small caps and value stocks as a group have underperformed b.c. they had worse factors then Google and Co.
There is just too much junk in the russel 2000 to be able to keep up. (Reason behind that, huge scalability and network effects of google and co, which are basically monopolies).
Also:
The small cap effect is not really an effect, it is driven mostly by low volumne (e.g. small cap stocks with relative high volumne is the worst place to be long)
I am buying small caps with low volumne b.c. one can find small caps with great fundamentals / factors that are not buyable for the huge institutions (because of size) and playing a structual competetive advantage of a portfolio sub 1-3 Mill. That is a structural edge that can not go away as long as I can find stocks with low volume that have great factors.
So I do not care about the russel 2000 b.c. I do not buy a typical russel 2000 Stock: my stocks have less volume then a russel 2000 stock and better fundamentals / factors…
So I designed a book of strats that perform well in regime 1-3 and try to time regime 4.
Factors I use: Momentum, Low volatility, Industry Momentum, Value, Quality, low volume + everything through a lense of Rate of Change (e.g. improving ranks!) especially when it comes to earning estimates.

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When this thread was started, a lot of people were ready to abandon small value in favor of large growth. But guess what? Valuation matters. Here is the chart.

300 cheapest value stocks in red.

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48

Great info Chaim.

Although not purely a value play, the ETF “RWJ” has produced a similar overall return over the same time frame (about 170%). A lot simpler to invest in. I have had some money in it for about 6 months now.

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Chaim and all,

This is not my strength so just a quick question: At least in retrospect, doesn’t Marc give a good reason as to why growth stocks have been underperforming with the Dividend Discount Model (DDM)? Growth underperforming and value doing better?

Even if one believes Tesla’s story on growth haven’t those future (expected) revenues been discounted more in the recent environment of inflation and rising interest rates?

Obviously, any expansion or corrections from Marc (or anyone else who truly understand this) welcome.

Jim

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Changes in inflation affect different types of companies differently. Warren Buffett wrote about this years ago (late 1970’s early 1980’s?). Commodity companies (and other value stocks) don’t necessarily benefit if costs go up as fast as revenues, while strong moat companies (a category which overlaps large growth) simply raise prices with inflation an continue making a high ROI.

However, people overestimate the correlation between earnings growth and stock prices while they underestimate the correlation between valuation and stock prices. You can see this very clearly when backtesting growth vs value.

Over the long term people often overestimate the discounted cash flow of growth companies vs the discounted cash flow of value companies. This is a bias that we take advantage of. An exception was the period from when the dot com bubble burst (in 2000) through 2013 when people actually underestimated future earnings growth of big tech in particular and large growth in general. It’s human nature for generals to favor strategies that worked in the last war.