It’s been more than 30 years since Eugene Fama and Kenneth French popularized the concept of a small-cap premium, and academics continue to debate its existence. Since the release of their “three-factor” model, reams of academic literature have argued for—or against—the small-cap premium. But it’s the naysayers who are louder today. They come by their skepticism honestly, as large-caps have outperformed for more than a decade.

Looking ahead, can one still argue that small-caps will outperform over the long term? And if there isn’t a small-cap premium, do small-caps still warrant a place in a portfolio, given the additional risk?

The Wasatch View: Much Depends on Timing

At Wasatch, we wouldn’t argue for or against a structural small-cap premium. Like many return-level debates, one could prove or disprove the premium based on the starting and ending dates used to measure performance. For example, if one looked at U.S. markets in the decade following the tech bubble collapse, they would be big believers in the small-cap premium. If one only looked at returns over the most recent decade, they would sit firmly in the skeptic camp.

The reality is that both large- and small-caps undergo long cycles of outperformance. From a diversification standpoint, investors likely benefit from owning both market-cap segments.

However, we believe there is a more compelling reason to allocate to small-caps than diversification or the potential existence of a small-cap premium. Simply put, the market segment provides investors the most opportunities to find high-quality companies that grow at structurally high rates over long time horizons. Add in the fact that among high-quality, long-duration growth companies, small-caps currently trade at much lower valuations than large-caps, and the case for allocating to small-caps becomes even more attractive.

Small-Caps: A Rich Opportunity Set for High-Quality, Long-Duration Growth Companies

A high-quality, long-duration growth company can be defined in various ways, but at Wasatch, we’re typically looking for companies with above-market revenue and earnings growth, strong returns on assets and invested capital, low debt and the ability to self-fund future growth initiatives. We often expect the earnings of our companies to double in five years and double again in the next five. Holding these types of companies over extended periods as they compound earnings growth can create attractive return streams for investors.

The chart below puts the return potential of small-caps in perspective. It shows the number of stocks in both the Russell 2000 Index and S&P 500 Index that have doubled each calendar year. Active investors aren’t going to find all of the companies whose returns double in a year. But in our history, we’ve found that focusing on companies that can generate consistently high growth rates with high-quality characteristics provides a good starting point for identifying stocks with the potential for high returns.

While investors can find high-quality, long-duration growth companies in any market-cap segment, the opportunity set has historically been greater within the small-cap universe. The chart below shows how much greater. The two lines show the number of high-quality, long-duration growth companies in the market segments below and above $30 billion. We chose $30 billion as the cutoff for our analysis because $30 billion and below is the general focus of Wasatch’s micro-, small- and mid-cap investment strategies. We defined high growth and high quality as any company with a three-year average sales growth and return on assets (ROA) level above 7%. The small-cap arena has consistently included more of these firms.

Part of the reason the small-cap universe has more high-quality, high-growth companies is simply because it’s a much larger pool of companies. Due to the sheer number of businesses in the small-cap universe, one would also find more low-quality companies and businesses that are yet to generate positive earnings. But for active investors such as Wasatch that focus on high growth rates and high quality, the small-cap arena provides a much more fertile hunting ground.

Valuation Disparity Makes the Small-Cap Case More Compelling

We’ve always favored small-caps because of the deeper pool of high-quality, long-duration growth companies. But we think current valuations in this segment make the investment case for small-caps even more compelling.

As the chart below shows, valuations of high-quality, long-duration growth companies among large-caps and small-caps have historically been in rough alignment. But in 2021, a valuation gap emerged, and high-quality, high-growth large-caps have since had much higher price-to-earnings ratios.

While we think it would be hard to prove that a permanent, structural small-cap premium exists in markets, we believe the deep pool of high-quality, long-duration growth companies in the small-cap universe—currently trading at a valuation discount to the same type of large-cap company—creates a strong rationale for allocating to small-caps today.

RISKS AND DISCLOSURES

Investing involves risk, including the potential loss of principal.

Information in this document regarding market or economic trends, or the factors influencing historical or future performance, reflects the opinions of management as of the date of this document. These statements should not be relied upon for any other purpose. References to individual companies should not be construed as recommendations to buy or sell shares in those companies. Past performance is no guarantee of future results.

The Russell 2000 Index is an unmanaged total return index of the smallest 2,000 companies in the Russell 3000 Index, as ranked by total market capitalization. The Russell 2000 is widely used in the industry to measure the performance of small company stocks.

The S&P 500 Index includes 500 of the United States’ largest stocks from a broad variety of industries. The Index is unmanaged and is a commonly used measure of common stock total return performance.

Indexes are unmanaged. Investors cannot invest directly in an index.

All rights in the Russell Indexes vest in the relevant LSE Group company, which owns the Index. Russell ® is a trademark of the relevant LSE Group company and is used by any other LSE Group company under license.

These Indexes are calculated by or on behalf of FTSE International Limited or its affiliate, agent or partner. The LSE Group does not accept any liability whatsoever to any person arising out of (a) the use of, reliance on or any error in the Index or (b) investment in or operation of the Wasatch strategies or the suitability of the Index for the purpose to which it is being put by Wasatch Global Investors.