For the past decade, the market has been dominated by large cap growth stocks, but there’s a subtle shift on the horizon that investors should pay attention to. In the battle of large cap vs small cap, recent data suggests that small caps might be gearing up for a comeback.
Between December 31, 2012, and December 31, 2022, large cap growth stocks, as represented by the Russell 1000 Growth Index, outperformed their small cap counterparts, the Russell 2000 Growth Index, by nearly 5% annually. However, it’s not just growth stocks that have seen large caps dominate; a comparison of the iShares Core S&P Small-Cap ETF with the S&P 500 indicates that large caps, encompassing both growth and value stocks, have been on a winning streak.
Surprisingly, the current landscape suggests a potential reversal. The ratio of the Russell 2000 to the Russell 1000 is at a 22-year low, indicating that small caps are currently undervalued compared to their larger counterparts. Historically, such instances have heralded excellent opportunities for small cap investments, as seen in the early 2000s when small caps outperformed large caps by over fourfold for 13 years.
Moreover, small caps aren’t just attractive relative to large caps – their absolute valuation is compelling too. With a forward P/E ratio of 12.6, the S&P SmallCap 600 Index is at its lowest valuation in the past two decades, except for the bottoms of the 2008 financial crisis and the COVID-19 crash in March 2020 – both periods when investing in small caps proved highly profitable.
The recent rare four-month decline of the Russell 2000 further strengthens the case for small caps. Historical data shows that after such declines, the index has delivered impressive returns – averaging 24.7% for one year, 21% for three years, and 16.8% for five years.
While large caps are currently on the expensive side, small caps present an almost historically attractive value proposition. With the market operating in cycles, the prolonged dominance of large caps suggests a potential surge in small cap performance. This shift is substantiated not just by historical performance but also by the recent unusual decline in the Russell 2000.
For income investors, this is a call to action. Small cap businesses are now offering solid dividends, robust balance sheets, and enticing valuations. As the market prepares for a potential tilt, it might be time for income investors to reassess their portfolios and consider the promising opportunities that small caps present.
Sven Franssen