A few weeks ago, we looked at the performance history of Value vs. Growth and observed that the history was prone to longer streaks. This week, we’ll look at the performance history between large-cap names and small-cap names using the Russell 1000 as a proxy for large-cap, and the Russell 2000 index as our small-cap index. According to Russell Investments, the Russell 1000 Index , “…measures the performance of the large-cap segment of the U.S. equity universe…” and, “…represents approximately 92% of the U.S. market.” Alternately, the Russell 2000 Index, “…measures the performance of the small-cap segment of the U.S. equity universe.”
As with the data series pertaining to growth and value, small-cap performance relative to large-cap performance has also been subject to longer trends. Let’s begin by presenting the yearly performance data (simple, i.e. no dividends included) for both indices going back to 1979. Below, we show the annual return for both indices, and the difference in performance for each year. A negative number in the “Difference” column represents underperformance by the larger-cap Russell 1000 in that given year.
 |
| Source: IronHorse Capital and Bloomberg |
From 1979 through the end of last year (34 years of data), the small-cap Russell 2000 index outperformed its larger-cap counterpart by approximately 1% per year, 9.36% per annum vs. 8.36% per annum. These performance numbers belie a wide range of performance outcomes when the numbers are examined by decade, or when broken down by the winning streaks for each series identified in the data set.
Going by decades, you can see that larger-cap names outperformed significantly during the secular bull market years of the 1980s and 1990s, but have underperformed during the secular bear market we have experienced since 2000.
Eyeballing the annual data series above, and moving beyond the confines of tidy decades, it appears that outperformance and underperformance regimes run for approximately 15 years or so, again roughly in-line with the broader secular bull/bear positioning in the market. From 1999 through 2012, 14 years, small-cap names outperformed 10 times with a cumulative return over that time frame of 101.29% vs. 22.87% for the larger-cap Russell 1000. On the flip side, from 1984 to 1998, 15 years, the Russell 1000 outperformed 9 times. Cumulative performance: 611.3% for the Russell 1000, 275.8% for the Russell 2000 small-cap index. Of note, prior to the 1984 turn towards a large-cap streak, the Russell 2000 small-cap index had outperformed for 5 straight years from the late 1970s through the early 1980s recession years, which happened to mark the end of the 1968 to 1982 secular bear market.
It seems counterintuitive that small-caps would outperform large-caps during secular bear markets in light of the fact that small-caps would seem to benefit more from consistent, strong economic growth, usually a feature of secular bull periods, lower volatility, another characteristic of secular bull markets, and better access to debt and equity capital markets (theoretically better during secular bulls). Various analysts ascribe performance differentials to everything from the direction of interest rates and inflation in bull and bear periods to growth in real GDP. Looking back at various data sets, there doesn’t seem to be a consistent pattern to create a storyboard when it comes to macro data. For instance, small-caps outperformed during the 1970s and early 1980s according to Ned Davis Research, a period defined by rising interest rates and inflation/stagflation (again, our available data set ends in 1979; we’ll have to take Ned Davis’ word). Small-caps outperformed during the 80s and 90s as seen above, a period defined by strong economic growth, declining interest rates, and declining inflation. This led some to conclude that higher interest rate environments turned out better for small-caps at the expense of large-caps. However, the 2000s have been defined by a continue drop in interest rates, and even lower inflation metrics. Nonetheless, small-caps reversed their underperformance and resumed a leadership position. We’ll leave it up to academics and others to ascertain the exact reasons why small-caps have been outperforming during poor overall market periods. Suffice to say, it’s a curious quirk in the data, but one that investors should pay attention to.
Based on the fact that large cap names have been mired in a long period of underperformance (nearly 15 years) that matches the length of past streaks, it seems small-caps may be pushing the limits with the current winning streak. Valuation may confirm this as well. At the last major performance turn, small-caps were consistently overvalued versus large-caps on an EV/EBITDA basis. At the end of 1998, for instance, the Russell 2000 was trading at 10x EV/EBITDA vs. 13x for the Russell 1000. That situation is now reversed. The Russell 2000 is now trading at approximately 12x vs. 9.5x for the Russell 1000.
Taking all into consideration, we believe large-cap will outperform small-cap in coming years, and based upon the data on growth and value we outlined in an earlier post, believe value will take the performance baton back from growth. As with our last post, we’ll leave you with a chart that gives a visual representation of small and large-cap out/under performance through the years.
 |
| Source: IronHorse Capital and Bloomberg |
