The modest improvement in the market has ignited a debate over the expected relative performance of small cap companies versus large cap. It has frequently been noted that small caps tend to outperform when markets rebound. The traditional rationale has been that the limited liquidity of small companies has made their share performance more vulnerable to investment flows. In a recovering market, it is argued that investors returning to stocks will disproportionately move small cap companies more than large cap for this reason. The chart below appears to support this:
The indicator line in the upper panel was created by dividing the Russell 1000 Large Cap Index by the Russell 2000 Small Cap Index. A rising line indicates a period when large company stocks outperformed small company stocks. Conversely, a falling line indicates small company outperformance. Those who ascribe to the belief that small companies will outperform in 2009 point to the 1991-1994 period following the 1990 bear market and also point to the strong relative performance of small caps following the dot-com bust. However, these two periods do not tell the entire story and may be misleading.
My belief is that 2009 will offer better prospects for the large cap investor. Those who look to history would be better off examining the relative outperformance of large companies in the period following the 1987 Crash. In the current environment, just as in the aftermath of the ’87 Crash, investors are risk-averse. This suggests that they will return only gradually to the market and will not create the kind of liquidity push that powered small caps in the past. Moreover they will have a preference for the perceived safety and liquidity of “brand name” large caps. The comfort level of large cap investing is augmented by the superior dividend yields of the larger companies; for example, according to the most recent Russell data, the Russell Top Fifty Index (50 of the largest U.S. companies) yields 3.29% compared to the small-cap Russell 2000 Index yielding 2.03%. That’s 62% more income on average, with substantially higher yields available in select large-cap names.
There are other reasons to believe that large cap companies will outperform. For one, there is a certain cyclicality to this — the extended period of small cap outperformance (roughly since 2000) is simply getting “long in the tooth.” More fundamentally, the U.S. dollar, while having apparently stopped its long decline, remains near historical lows — this generally is seen as benefiting large companies since they typically have a greater export orientation. Finally, the likelyhood of increased government regulation of business works to at least the relative advantage of larger companies. This benefit is generally achieved by the superior ability of large companies and their lobbyists to influence legislation and regulations (often to the detriment of smaller competitors). In the current environment, large companies may also be the direct beneficiaries of “too big to fail” largess. Regardless of the mechanism, 2009 may finally be the year that patient large cap investors are rewarded.