LARGE CAP vs SMALL CAP STOCKS

I received a good question from a client this week that I wanted to share with you.  Ed wrote me the following:

“I recently read you don’t like the Russell 2000, but do you ever use it when it’s having a good year?”

This is an excellent question, and I think many people will be interested in my answer since the financial professionals are always telling people to include some small cap stocks in our portfolios. 

I have decided that I would like to do more posts about questions from my customers.  I often get similar question regarding International Funds, Tech Funds, etc.  I’ll be posting similar replies to those questions soon. 

As you know, I am a data geek and a logic nerd.  The positions I take derive from lots of analysis of data.  And I mostly rely on long term data.  Any investment can post great results over a short period of time – 3 months, 6 months, 1 year.  But if it has inconsistent performance and its long-term performance is not great, I don’t want to bother with it. 

The Russell 2000 (small cap stocks) has had some brief shining moments.  But compared to large cap funds like the S&P 500, it comes up short in the long run.  Let’s look at the data.

If you’ve read my most recent book, Picking the Best Funds for Your 401K, I explain my decision-making process for evaluating funds or any investment.  Without a rigid and consistent process to evaluate investments, people are using gut and emotions which rarely work.  I am never interested in opinions about investments if they are not backed up by rigorous analysis. 

Here are the three main areas that I use to evaluate any investment.

1. Performance – particularly long-term performance (10 years, 20 years, 30 years).

2. Consistency and Volatility – Consistency equals predictability.

3. Conviction – Knowledge and understanding of an investment and why it should perform well keeps you committed to the investment.

Risk is another important consideration, but these three categories address risk in their own ways.

Let’s compare the S&P 500 index funds (large cap stocks) as an investment against the Russell 2000 index funds (small cap stocks) by running through my three key criteria.

Performance

I always want to look at long-term performance.  For this analysis, I am going to use performance data for the last 30 years.  I am showing each investments returns including dividends.  I am interested in total returns.  The S&P 500 has typically paid higher dividends than the Russell 2000.  Some people have a bias towards stocks that pay higher dividends.  I don’t really care.  Total returns are all that matter.  Stocks that pay higher dividends tend to hold up better in market downturns but that factors into the consistency and volatility category.  Stocks paying higher dividends tend to have lower overall returns.

Here are the performance statistics for the two funds over the last 30 years.

If you started in 1995 with $100,000 invested in each fund, you would have ended up with $2,118,000 at the end of 30 years with the S&P 500 and $1,280,000 in the Russell 2000 – or $828,000 more.

The S&P 500 is the clear winner for long term performance. 

Consistency & Volatility

In this next view of performance, we want to look at the detailed performance over the 30 years.  Did the S&P have big gains in one decade and weaker performance in two decades?  This would make me less confident in its performance.  I like to look at individual years the same way.

How did the two funds perform during bear market declines?  This tells us about volatility.

There is not much difference in performance between large cap and small cap funds in bear markets.  The Russell 2000 did better in the dot-com collapse but similar or slightly worse in the other bear markets.  There is no real advantage for either in bear markets.  They both get crushed.

How about the 30 annual time periods?

When you study the annual data, the annual volatility is similar between the two investments.  You can see by the chart that they move together.  The Russell 2000’s performance is helped by strong performance in four or five years, so it is a little less consistent.

How about the data prior to 1995?  I have less confidence in data going back 40 or 50 years or more particularly with small cap stock classifications.  The way small cap stocks are categorized in the 1960s is not the same as it is today.  The S&P 500 data is very consistent going back 100 years.

Large cap stocks won big in the 1980s and the 1990s.  Small cap stocks had huge gains in the late 1960s and the early 1970s.  There was another short time in the 1940s where small cap stocks outperformed.  Again, I have the same issue with consistency with small cap stocks. 

The S&P 500 is a slight winner when it comes to consistency and volatility.

Ed’s question contained another question – “do you ever use the Russell 2000 when it is having a good year.”  I only care about where I think an investment is going and not where it has been.  The Russell 2000 does have short-lived hot streaks, but it is too hard to predict for me or to get that timing right consistently.  You have to be right most of the time playing this kind of timing game to make it worthwhile. 

The performance of the Russell 2000 has lagged big time over the last few years so maybe it is due for some strong years.  But I like to play the long game where the odds are in my favor. 

Conviction

Understanding an investment leads to more conviction in that investment. 

Gold is an example of an investment that I would have no conviction over.  Yes, gold does tend to outperform stocks in bear markets, but it performs so much worse most of the time that you are only going to lose by owning gold in the long run.  If anyone could accurately predict bear markets, then they could get in and out of gold at the appropriate times but nobody can do this.

The key issue here though is conviction.  If you follow gold and the supply and demand story of this commodity, you soon realize that nobody understands what makes gold go up in value or down in value except after the fact.  I could come up with some great stories about why gold has been on such a strong run recently, but anyone that tells you they saw it coming is not being honest. 

When I have no idea why gold goes up or down, I have no conviction.  Gold doesn’t produce any earnings that we can analyze.  It doesn’t pay a dividend. 

Let’s view our two funds through that same lense.  Both the S&P and the Russell 2000 are highly diversified and include some great companies and some mediocre companies.  They both produce earnings which we can track, and they both pay dividends (a little higher for the S&P).  They both represent stocks that trade on US stock exchanges and both have companies that do business overseas. 

The only difference is company size. The S&P 500 contains large cap stocks (bigger companies) and the Russell 2000 contains mostly small cap stocks (smaller companies).  The S&P 500 is made up of the biggest and the best companies in the world.  The biggest companies are getting bigger and stronger, and it is getting harder for smaller companies to compete against them.  Think of Amazon in retail and Google in tech.  I am not making any value judgements about this being a good thing or bad thing, but it is hard to see small companies winning many wars in any industry today. 

The small companies do have more growth potential because they are small.  There will be a big dominant tech company or two that emerge from the Russell 2000 in the next decade, absolutely.  But I can’t tell you which one and it is really difficult for one or two stocks to pull up the average of the 2000 stocks in the Russell index.  And those winners will become part of the S&P 500 eventually and they will leave the Russell 2000.

The performance statistics help back up my conviction for the S&P 500.

The S&P 500 wins here as well.  It is a clean sweep.

The Russell 2000 is not a bad fund.  It’s returns over the last 30 years are much better than most other investments.  It is just not as good as the S&P 500.

I think you can see now why Warren Buffett says that all individual investors should just buy the S&P 500 and forget about it. 

We agree mostly with Mr. Buffett, but we find times when tech funds and higher growth funds have a role to play.  And we definitely don’t agree with the “forget about it” part.  Buy & Hold is a very costly strategy when you have a tool like our Market Signals to avoid getting crushed in ugly bear markets.  Until we created Market Signals, Buy & Hold & Suffer was the only game in town.  Now, everyone can get high growth AND loss protection. 

We stick with the S&P 500 index funds, and the Nasdaq index funds and things like the Nasdaq 100 (many good funds like the Nasdaq 100 exist).  I’m working on a post like this one comparing the S&P 500 to the tech-heavy funds like the Nasdaq. 

Send me your questions and I’ll try to include my answer in an upcoming blog post.

Stay Disciplined My Friends,

Phil McAvoy

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