Small Cap Stocks Were the Place to Be the Past 10 Years

By on December 13, 2010

Paul Lim, writing for the N. Y. Times, points out how while investors may have been burned by owning large cap stocks over the previous decade, those who focused on small caps were handsomely rewarded.

This year, the Standard & Poor’s 600 index of small-company stocks has gained 25 percent. That is nearly double what the S.& P. 500 index of large stocks has returned year to date. Even more impressive is that small-cap stocks are up around 8 percent annually over the last decade, a period in which blue chip stocks have gone nowhere, with an annual return of 0.8 percent.

Lim also points out the recent dismal performance of long term bonds and how investors might be enticed into investing in large-cap equities:

As interest rates have risen recently, the average long-term government bond fund, for example, has lost more than 9 percent in the last three months. Many municipal bond funds and some corporate fixed income portfolios also have had losses recently.

The stunning small-stock performance could push fearful bond investors back into stock funds, which have had net outflows of more than $40 billion since the start of 2009. And that could provide a boost for the blue chips down the road.

Lim cites research from Sam Stovall and James Stack backing up a resurgence in the performance of large cap stocks:

Sam Stovall, chief investment strategist for Standard & Poor’s, studied the performance of large and small stocks in bull markets going back to 1949. He found that typically, small stocks outperform blue chips by a wide margin in the first 12 months of a new bull market. Small-company stocks also maintain a slim lead in the next 12 months.

But. he said, “in the third year of a bull market, investors prefer larger boats, as they expect the seas to become a bit more treacherous.”

James B. Stack, editor of the InvesTech Market Analyst newsletter and a market historian, agrees. “Historically speaking, as bull markets age, investors tend to grow more conservative,” he said. “I’ll be surprised if we don’t see the S.& P. 500 perform as well or better than small caps in 2011.”

Finally, Lim gets to the valuation differences favoring appreciation of large cap equities in the future:

THE recent surge in small-cap stock prices has made large caps attractive in another way: their valuations are cheaper. After the recent rally, the S.& P. 600’s price/earnings ratio stands at 27. That’s a 75 percent premium to the P/E ratio for large stocks.

In recent decades, small stocks have traded at a slight premium to the broad market, but since 1995 that premium has averaged only 15 percent.

“Frankly, I find valuations on large caps much more compelling than for small,” said Thomas H. Forester, manager of the Forester Value Fund.

He adds that he also likes blue chips because they have been out of fashion for so long, “From the standpoint of a contrarian investor, when you see something happen for 10 years, you shouldn’t expect it to continue to outperform over next 10 years.”

SMA Comment:  Jeremy Grantham has been touting high quality large-cap equities for quite some time now.  I remember back in the early 2000’s when no one wanted to own small cap stocks after they had underperformed for 7+ years running.  That is when they should have been accumulated.  Although large caps have had decent returns over the past 1 1/2 years, their performance still pales in comparison to other asset classes.  The large cap stocks are probably the last relative bargains left.

Source:  The N. Y. Times
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