What is a Small Cap Stock?

Everyone seems to have a different answer to that question. Many analysts and portfolio managers consider a market capitalization of less than $1 billion to be small. Others prefer a cut-off point of $500 million, and still others the $250 million mark. For our purposes, we consider the small cap universe to consist of the bottom 10th percentile of all stocks. A study by Oppenheimer Capital reveals that small cap stocks have outperformed the S&P 500 by a wide margin since 1925. For each $1 invested, the S&P 500 returned a total of $517 by December of 1990, for a compounded rate of return of 10%. That's not bad, especially considering that inflation averaged in the low single digits during that period. But how did our small cap universe fare? The same $1, invested in the smaller issues in 1925, produced a compound rate of return of 12%. The extra two percentage points means that our $1 investment grew to $1,277 versus the $517 yielded by the S&P 500.

Who's Winning the War?

What about the war mentioned in the first paragraph? Since the second quarter of 1983, the Russell 2000, a commonly used small cap index, has underperformed the S&P 500 by a factor of better than two to one. Why were the 1980s so kind to the big guys? Perhaps the answer to that question can be summed up in two words, index arbitrage. The development of hedging strategies employing futures and options revolutionized portfolio strategy for many institutional investors. While the merits of index arbitrage are debatable, its influence on financial markets is quite clear. To hedge a portfolio using index arbitrage, you have to own the underlying stocks. For many money managers, this closed the door on the smaller, less liquid stocks. Often portfolio managers turn down research ideas that they like but can't buy.

Another phenomenon of the 1980s was the globalization of investing. Foreign investors, mainly Japanese, British, and German, poured capital into U.S. equity markets. Obviously, these long-distance investors had to rely on Wall Street research in many cases. Because of the massive overhead at most major brokerage firms, the research efforts had to focus on the more liquid large cap stocks, which incidentally could be matched to index arbitrage programs. Information is indeed king, but the type of information supplied is generally influenced by the type of information demanded.

Other Forces at Work

To further explain the success of the S&P 500 over small caps in the 1980s, we must remember the abandon of the takeover artists. Lower interest rates after 1982 unleashed a flood of deals for the sake of making deals. How can we forget the rise of bearers of information who told us of the next hot target? Why bother with smaller, lesser-known companies when you could get rich owning options on RJR Nabisco or Kraft?

Finally, it is possible that the falling value of the U.S. dollar in the second half of the 1980s exaggerated the performance of the bigger cap stocks. Companies with overseas interests (mainly larger firms) reaped earnings windfalls due to currency gains. Higher earnings mean higher stock prices.

Okay, we've established that 1983 to 1990 was a period of underperformance for small cap issues. What has happened after similar periods of underperformance is shown in Figure 1.

Clearly, Figure 1 shows that the ebbs and flows of relative performance between the S&P 500 and the small caps are quite significant. But, is there any correlation of the relative performance of the two groups versus the business cycle? Figure 2 is offered as positive evidence of this.

Why do small caps outperform following a recession? Could it simply be because they are beaten down further than large cap issues in the first place? Perhaps. It may also be due to a belief that smaller, less bureaucracy-laden firms can recover more quickly as business conditions improve. Will 1992 be such a recovery year? If so, history dictates that small caps may be the place to be.

The Impact of Liquidity

So far, we have discussed the relative performance of small cap stocks over large cap issues and have attempted to explain some of the reasons why. But we have not addressed the most central of all themes when talking about small caps' liquidity, or the lack thereof. Certainly, smaller companies have fewer shares outstanding. As mentioned earlier, large brokerage houses tend to concentrate their research and market- making efforts on larger issues. It would not pay for Merrill Lynch to recommend a small cap stock if its own massive sales force could buy every share three times over. The lack of coverage by Wall Street produces a highly inefficient market for small cap stocks. It is this inefficiency that breeds opportunity. Because smaller regional brokerage firms generally cannot provide much value-added insights on IBM or General Motors, they concentrate on the lesser-known companies. Smaller, sometimes single-product companies can be easier to analyze, thus further improving the focus and productivity of regional brokerage firms' research efforts.

Where do we go from here? In the 1960s and 1970s, U.S. companies sought to diversify to smooth out the cyclical effects present in most industries. In the 1980s, U.S. businesses faced growing global competition. Some of these megaconglomerates could not reach quickly and decisively to meet new challenges.

Suddenly, specialization has become the new buzz word. Many companies are now spinning off unrelated businesses and small, lean enterprises are finding many niche opportunities. Ditto for the merger and acquisition craze of the 1980s. Many of those debt-laden giants are spinning off divisions to improve their balance sheets. All of this points to more specialized companies competing in limited product areas where all of their resources and attention can be finely focused. If smaller is better for corporate America in the 1990s, perhaps the same will hold true for small cap stocks as well.