Small but Fierce…Stocks

“Though she be but little, she is fierce!”William Shakespeare, A Midsummer Night’s Dream

For much of 2018, technology giants Facebook, Amazon, Apple, Netflix, and Google (the so-called FAANG stocks) have dominated market-related headlines. While these companies have driven a disproportionate amount of the year’s stock gains, their performance has overshadowed what has also been a fantastic year for small company stocks. Through mid-September, small U.S. stocks (Russell 2000 Index) have returned 13.1% while large U.S. stocks (Russell 1000 Index) have returned 10.3%. Furthermore, small growth stocks have outpaced large growth stocks 17.5% to 16.4%, respectively.

What are small companies? Why are they doing so well? And what does their performance mean for the market as a whole?

What are small companies? Simply put, small companies are those with a market capitalization of between $300 million and $2 billion. Now those market cap figures may not seem “small,” but compared to the $1 trillion market capitalizations of Apple and Amazon, one can see that small companies are pretty “small” relative to these market behemoths. It’s also important to understand that while there are far more small publicly traded companies than large publicly traded companies, on a market capitalization basis, large companies collectively comprise more than 90% of U.S. (and global) market cap.

Why are small companies doing so well? In general, small companies outperform large companies over time. This has been proven through Nobel Prize winning research by Eugene Fama of the University of Chicago. The main reason for the outperformance is that small companies are more risky than large companies and theoretically, one should get compensated by higher returns for taking on the extra risk of owning small companies. Another reason may be that small companies often don’t get the same coverage (analyst and otherwise) as large companies and are therefore overlooked, mispriced, or underpriced as a result. Think about how much the FAANG companies are in the news compared to much smaller companies that have performed just as well if not better. Fama’s research has been a foundation of BDF’s investment strategy as we have historically maintained an overweighting to small company stocks (relative to the market) in our portfolio.

When it comes to 2018, there are additional reasons why small companies have fared so well. For one, the corporate tax cuts passed late last year really boosted small companies’ earnings. And, because small companies tend to be more domestically focused in their sales, operations, etc., they have not been as affected by the trade skirmishes and the stronger dollar that have especially impacted large U.S. companies and companies outside the U.S.

What does their performance mean for the market? Even though the current bull market is not the strongest in history, it is the longest. And a key to the longevity of any bull market is stock market breadth. Breadth is a measure of how many companies are advancing in value versus declining in value. If the market were being solely driven by a single asset class or handful of companies (as was the case with technology stocks in the late-1990s), that could be ominous for the market overall. However, this bull market has seen multiple asset classes spend time at the top of the heap. For instance, in 2016, small and value-oriented companies did the best. In 2017, international companies (developed and emerging markets) did the best. And this year it’s been small and growth-oriented companies on top.

The strong performance of small cap stocks is a good thing as it illustrates that this bull market is supported more broadly than by a single asset class or group of companies. That may be a reason for the current stock rally to extend longer than some might think.