Small capitalization companies overdue for a bounce in 2020

Large capitalization U.S. companies continued to outperform last year.

The Russell Top 200 mega-cap index gained 30 percent last year, while the Russell 2000, a group of about 2,000 companies that average only $2.43 billion market value rose 23 percent.

Since 2016, on an annualized basis, the small cap Russell 2000 gained about 8.1 percent, while the mega-caps gained 15.7 percent.

Are small-cap stocks ready to reclaim their traditional lead in performance?

Over the long-term small cap stocks are supposed to outperform large caps. This is based on the premise that small-cap stocks are riskier than companies like Microsoft, so investors deserve a reward for taking on more risk. Small-cap stocks are also more volatile than large-caps, so investors expect to be rewarded for the extra stress involved in owning small-caps. And that relative outperformance of small caps happened as expected, until about 2010.

This abnormal reversal of roles between small and large caps is triggering some people to forecast a rebound for the “little” guys, if little is the right term for a company worth billions.

While it’s hard to know for certain what caused the recent performance edge in large cap stocks over small caps, the dominance of the FAANG group of stocks probably was a major contributor. The FAANG group includes Facebook, Amazon, Apple, Netflix and Google (Alphabet).  Many investors add Microsoft to this group, although it doesn’t fit into the acronym.

It’s likely, too, that the growing popularity of exchange-traded funds, or ETFs, has contributed to this phenomenon as money that is added to an ETF gets allocated to individual stocks based on market capitalization. So, a dollar added to a broad-based ETF with the FAANG stocks and Microsoft would have about 20 percent added to just those six companies while the others would get less, much less. The smallest companies would be bought in very small quantities, or often not at all if the operator of the ETF didn’t bother to buy them and wasn’t worried about tracking error between the ETF and the market.

This smaller buying pressure on small caps means that recent valuations are more reasonable compared to large caps so there could be bargains in that segment of the U.S. stock market.

There are other reasons for anticipating a move away from large caps.

The controversy over protection of personal data threatens the prodigious money-making machines of Google, Amazon and Facebook. California passed the California Consumer Privacy Act, or CCPA, that took effect on January 1, requiring companies like Facebook to notify consumers of the intent to make a profit off the data provided by consumers. The law requires that consumers be given the choice to opt-out of allowing the use of their personal data for profit.

Europe is way ahead of the U.S. in regulations as the EU’s GDPR, or General Data Protection Regulation, has been around since 2018. The EU has hit Google with three separate prosecutions since 2010 on for their methods of selling advertising, collecting more than $9 billion in fines.

Regulatory and tax problems are more likely to be big company issues. Small caps are seldom targeted for tax avoidance and anti-trust violations. Small companies also are not affected as much by a trade war between China and the U.S. And threats of war with Iran are less likely to affect those whose business is closer to home.

Smaller companies will benefit from the move away from globalization, a trend that is gaining strength as exemplified by Brexit and the rise of populist sentiment against trade.

2020 could be the year of the small caps.

 

Hilliard MacBeth

 

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