Small-company stocks, once a reliable growth engine, have been struggling for years. Fortunately, there are some portfolio tweaks that may help you beat the slump and collect the outsize gains small-caps have historically delivered.
The problem goes beyond the stocks’ prices. Today, only about 60% of small-cap stocks in the
are profitable, down from 70% before the pandemic. It is one of the lowest levels since the 2008-2009 financial crisis.
Small-caps typically represent only a sliver of investors’ U.S. equity holdings: 5% to 10%, if you weight by market values, as index funds do. But they have historically been an engine of outsize returns because of what academic research has called the size factor.
If you go back to 1927, small-caps have returned 11.7% a year, on average, notes a recent post by investing writer Larry Swedroe. That beats the return of large-caps by about 1.6 percentage points a year. As a result, “the size effect was incorporated into what became finance’s new workhorse asset pricing model,” which sophisticated investors use to evaluate potential ways to put their money to work, Swedroe writes.
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No one is quite sure why so many smaller companies are floundering. One theory is that years of near-zero interest rates helped keep too many iffy companies afloat. Another is that, partly because of onerous regulations, many attractive, fast-growing companies are choosing to stay private.
What can investors do? One solution is to try to re-create the small-cap market of yore by titling your portfolio toward smaller companies that are profitable.
The S&P Small Cap Quality Index has returned 9.8% a year over the past decade, beating the generic version of the index by 1.6 percentage points. Its returns nearly matched those of the S&P 500 until 2023, when the market’s megacaps really began to take off.
A number of exchange-traded funds target quality stocks—typically defined as those with steady profits and strong balance sheets. The $41 billion
iShares MSCI USA Quality Factor ETF
is one, while the $8 billion
Dimensional U.S. Small Cap ETF
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is another.
Another strategy, according to Swedroe, is to try to invest in the universe of attractive small-cap companies that have remained private. Private-equity funds offer one solution.
Buying those funds may involve qualifying as an accredited investor, with a $200,000 salary or $1 million in investible assets. It also has traditionally meant high fees and long lockup periods. However, Swedroe argues, newer funds from managers like Pantheon and J.P. Morgan, attempt to address these issues.
Write to Ian Salisbury at ian.salisbury@barrons.com
