A Look Ahead For Small and Mid-cap Stocks

This was a historically rough year for small-cap and mid-cap stocks. Small-caps underperformed large-caps by more than 10% in 2014. This sort of gap is very unusual; it has happened only a handful of times over the last half century. The last time was during the deflation of the dot com bubble; there had been lots of speculation in small-caps as the bubble inflated. The good news is that small and mid-caps historically outperform large-caps, this holds true especially for value small-caps. Looking back from January 1927 to August 2014, small-cap value stocks beat large-cap stocks by 6.24% annually. Over that same period, the premium to small-cap value was positive over 99% of 10-year rolling periods. As small-caps in general close the gap, we will take additional advantage using a value strategy.

The economy has strengthened over the past year. Jobs are up, real wages are up (for the first time in a long-time), consumer demand is up, and corporate investment is up. The price of oil dropped significantly in 2014, sending the stock market into a brief panic. Lower oil prices, however, are good for the overall economy boosting corporate profits and consumer spending.

In addition to the historic trends that indicate increased performance for small-caps (a reversion to the mean), there are fundamental signs of strength for smaller companies. One of the interesting themes going into 2015 is that small-cap stocks, unlike large-caps, will not be undercut by the continued strength of the U.S. dollar versus other currencies. A strong dollar is a negative drag on the profits of large U.S. companies that do significant business abroad: profits earned in weaker currencies shrink when they are exchanged back into dollars. Small and mid-cap companies generally generate the bulk of their earnings domestically and won’t feel the same drag. The U.S. economy is also showing more signs of strength than other world economies, which, because small-caps do the majority of their business domestically, should help small and mid-caps.

I plan on investing the rest of the available cash in client portfolios within the next couple months to take advantage of the gap in performance between small-caps and large-caps before it disappears. We may catch another downward spike in the market, but investing your portfolio for the long-term is the main target. Market timing is impossible to predict, and short-term movement will have minimal impact on your long-term performance.

I am confident that the macro-trends of small-cap outperformance will hold over the long-term. With the strengthening economy, and the upward pressure on small-cap prices, we are in a strong position going forward. The outlook for 2015 and beyond is very promising.

  1. Dear Mr. Durphy,
    Thank you for the insightful update!

    Devaluation of Russian Ruble against US dollar (and other currencies) is probably affecting large US companies that have operations in that country.

    I was applying Ben Graham’s criteria (From The Intelligent Investor) to screen the market for deals. I saw several Russian large-cap companies selling at low Price/Earning multipliers. Also some Japanese corporations (e.g. Kyocera) can be considered a bargain. What do you think about non-US large companies as an investment opportunity?

    Thank you in advance for your reply!

    • It’s always a little tricky to trade foreign stocks. If they’re traded in the U.S. on an exchange, they will have to comply with SEC regulations. If not, looking for fraud or misleading reporting can be difficult. Also, it’s hard to be an expert everywhere. Understanding Russian or Japanese economics can be difficult and time consuming. A Russian company may appear to be a good value, but oil prices and totalitarian governmental tendencies might push it into value trap territory.

      So, if you’re going to invest in other countries be sure to do your due diligence and watch out for any assumptions you might make based on your experience in U.S. markets.

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