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Are Small-Cap Stocks Worth Investing In?

Given their chronic underperformance, it’s a fair question.

Are Small-Cap Stocks Worth Investing In?

Key Takeaways

  • Small-cap stocks have a long-term performance advantage over large-cap stocks, and this is often referred to as the small-cap effect.
  • Small-cap stocks are said to be economically sensitive and therefore rally in recoveries and lag heading into recessions.
  • These truths have been upended in recent years as small-cap stocks have underperformed large-cap stocks in a variety of different economic climates.
  • A lot of portfolios are heavily tilted toward larger caps, and market leadership is cyclical. There have been periods, most recently in the early 2000s, when small caps led the market. There is the possibility of a leadership rotation in the future.

Susan Dziubinski: Hi, I’m Susan Dziubinski with the Morningstar. Small-company stocks have lagged large-company stocks for the better part of the past decade, and that’s leading some investors to wonder whether small-cap stocks are worth investing in at all. Joining me today to unpack the performance of small-cap stocks and bust some truths associated with investing in them is Dan Lefkovitz. Dan is a strategist with Morningstar’s Indexes group. Hi, Dan. Good to see you.

Dan Lefkovitz: Good to be with you, Susan.

Small-Cap Stocks vs. Large-Cap Stocks

Dziubinski: You recently published a new paper that examined some of these truths that have been associated with investing in small-cap stocks. Now, the first of these truths is this idea that small-cap stocks have a long-term performance advantage over large-cap stocks, and this is often referred to as the small-cap effect. So where did this reputation come from and what’s the thinking behind it?

Lefkovitz: There was some seminal academic research published in the ‘80s and ‘90s looking at many decades of stock market history. And it showed that over a long time period, companies with smaller market capitalizations had outperformed the overall market. And the theoretical rationale that emerged was that these smaller-cap companies—being more volatile or riskier, less proven, less liquid—compensated investors for the additional risk that they bear. So, you hear about the small-cap effect. You hear about the size premium or size anomaly often associated with factor investing. The idea that there are certain security attributes that lead to a performance advantage.

Are Small-Cap Stocks Economically Sensitive?

Dziubinski: Another truth around small-cap stocks is that they are said to be economically sensitive and therefore rally in recoveries and lag heading into recessions. Where did this particular piece of truth come from?

Lefkovitz: This is a real piece of conventional wisdom in the investment world. Small caps are perceived to be procyclical in nature. So more exposed to macroeconomic factors like changes in gross domestic products, interest rates, consumer demand, commodity prices. Small caps are certainly less diversified in their business models than larger caps and more domestically focused in their revenue.

Why Have Small-Cap Stocks Underperformed Large-Cap Stocks?

Dziubinski: Got it. But you say in your paper that these truths have been upended in recent years as small-cap stocks have underperformed large-cap stocks in general in a variety of different economic climates. So delve into that for us.

Lefkovitz: Well, just going back historically, if you look at the recovery from the great financial crisis, small caps did outperform in 2009 and 2010 in the U.S. market. But as you say, if you look at the past 10 years, 10-plus years, our broadest U.S. small-cap index, which covers the bottom 10% of the U.S. market, has returned about 6.5% on average over the past 10 years—the broad U.S. equity market, over 11%. So, it’s a massive gap. And as you say, it does include several periods of really robust economic growth and recovery, like 2021 when the market and the economy were bouncing back from the pandemic. And then this year, 2023, there was all that debate over whether the landing would be hard or soft. There’s been no landing at all. The third-quarter GDP growth in the U.S. was close to 5%, and yet small-caps have badly, badly underperformed. So, I’d say maybe I’d use a different word. It’s challenged the conventional wisdom. And I think investors have to be skeptical about some of these rules of thumb, some of this conventional wisdom about what does well and when.

Dziubinski: Tell us why then, Dan? Why have small-cap stocks underperformed over this stretch?

Lefkovitz: There are a lot of theories out there. And I think one thing that gets lost in all the talk of interest rates and growth and recovery, macro factors, top-down factors is just bottom-up fundamentals. If you look at our small-cap extended index, it has much more exposure to old economy sectors, which have underperformed, which have done poorly relative to tech, and more new economy areas of the market. So, our small-cap index is overweight financials and energy and materials and industrials and real estate, underweight technology versus the broad market and versus the large- and mid-cap segment. And technology has been far and away the best-performing area of the market.

If you look at the big investment themes that have driven market performance, it’s been digitization and the cloud and artificial intelligence. And we’ve also been talking about a small cohort of mega-cap techie stocks that have led the market for a long time. The “Magnificent Seven” you’ve covered this year, Susan, is responsible for the lion’s share of the equity market gain—Apple AAPL and Microsoft MSFT and Nvidia NVDA. It’s really been growth over value, large over small, and U.S. equities versus non-U.S. equities.

Dziubinski: The biggest detractor you would say has been that lack of technology exposure?

Lefkovitz: I think that the most powerful theme powering U.S. equities and equities globally has been... The benefits have been disproportionately reaped by larger-cap companies.

Why Did Small-Cap Stocks Lead the Market in 2016?

Dziubinski: Got it. You note in your research that the last calendar year that small-cap stocks led the market was in 2016. What was the dynamic in the market and the economy that might have led to the outperformance in that particular year?

Lefkovitz: It was interesting. That was an election year. And after the election results came in November 2016, the U.S. market experienced what was known as the Trump bump. So, there was a powerful rally among companies that were perceived beneficiaries of candidate Trump’s agenda. So, tax cuts and regulatory rollbacks, infrastructure spending, protectionism. Small caps did well, value did well, domestically oriented companies did very well, but it was really anticipatory, speculative in nature. And the market quickly rotated back to large-cap growth dominance.

Are Small-Cap Stocks Worth Investing In?

Dziubinski: Given where the markets and the economy are today, Dan, does it make sense for investors to consider investing in small caps if they haven’t already? Or if they are already invested in small caps, how should they be thinking about that exposure heading into 2024?

Lefkovitz: I think it does, Susan. I think a lot of portfolios are really heavily tilted toward larger caps at this point, just given their outperformance. And market leadership is cyclical. There have been periods, most recently in the early 2000s, when small caps led the market. And I think the possibility of a leadership rotation, I don’t know when it’ll happen, but there are certainly valuation signals that would be supportive of small caps taking over market leadership. So from a price-to-earnings standpoint, our small-cap index versus the overall U.S. equity market, the gap resembles what it did 20-plus years ago. And then Morningstar equity research, if you aggregate their price/fair value estimates at the company level, the segment of the U.S. market where they see the most opportunity, the most upside from a forward-looking valuation perspective is that smaller-cap segment.

Now, valuation again, is not a timing signal. It can take a long time for price and fair value to converge, but I do think it makes sense for investors to be prepared for a leadership rotation. And I will also note that Morningstar’s manager research team has observed that smaller caps are in an area where active managers have fared better than in larger caps. The small-cap universe is really large, and it’s diffuse, and a lot of companies struggle with profitability issues.

Dziubinski: Well, so don’t give up hope is what you’re telling us, Dan, right? Well, thanks for your time. It’s good to see you.

Lefkovitz: Thanks, Susan.

Dziubinski: I’m Susan Dziubinski with Morningstar. Thanks for tuning in.

Watch “2023 Has Investors Questioning All Sorts of Conventional Wisdom About the Market” for more from Dan Lefkovitz.

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Morningstar, Inc. licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. A list of investable products that track or have tracked a Morningstar index is available on the resources tab at indexes.morningstar.com. Morningstar, Inc. does not market, sell, or make any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.

The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.

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