For years large cap stocks have been trounced by small and mid cap stocks. Coming into 2006, most experts were predicting a move toward large cap outperformance. So far though that has yet to come to pass. In fact, the Russell 2000 small cap index gained 10 percent at the outset of the year, about triple the gain of the S&P 500.
Now it is true that historically larger companies do not advance as much as smaller companies. Small caps do best, followed by mid caps, with large caps bringing up the rear. This trend though has been even stronger than normal in recent years. Why is this true, and will it continue?
Stock prices in general are richly valued today, based on price-earnings ratios. As a result, stock price appreciation has not come from multiple expansion this decade, as it did in the 1990’s. Rather, earnings growth has been the only way to see outsized share price gains as multiples have either remained the same or contracted.
Common sense tells us that small and mid cap stocks will have an easier time growing earnings. After all, they are growing off a much smaller base of business. A $100 million company need only add an incremental $10 million in business to grow 10%, but Wal-Mart needs to add tens of billions of dollars in sales to reach the same level of growth.
Will small caps and mid caps continue to outperform? Over the long term, absolutely. However, the gap in performance may not be maintained at the levels seen in recent years. As you can see from the charts below, small and mid cap stocks are soaring, hitting new all-time highs.
S&P Mid Cap Index (MDY) vs S&P 500 – 10 Years
Russell 2000 Small Cap Index vs S&P 500 – 3 Years
Small cap stocks have also outpaced large caps by a factor of two…
Equal Weighted S&P 500 vs Market Cap Weighted S&P 500