Large-Caps Vs. Small-Caps

5/23/2011


The lure of higher returns draws many people to small-cap stocks. From 1926 through 2010, small-company stocks averaged annual returns of 16.7%, versus 11.9% for large-company stocks.

Despite the large discrepancy in average return, both groups generated similar risk-adjusted returns. Higher absolute returns and similar risk-adjusted returns sound good. Does that mean investors should load up on small-company stocks?

Not so fast. First of all, simple average returns tend to favor more volatile investments. Using the geometric average, which reflects the compounding of returns over time, small-company stocks delivered 12.1% annualized returns, versus 9.9% for large-company stocks. Based on geometric averages, large-company stocks generate better risk-adjusted returns than small-company stocks.

The effect of compounding

Why the difference between simple and geometric averages? Consider an investment that gains 50% the first year, then loses 50% the second year. The simple average return is 0%. But the geometric return considers that your $1,000 investment grows to $1,500 the first year, then shrinks to $750 the second year, generating a net loss of 25% and an annualized loss of 13.3% over the two-year period.

The geometric average return is always lower than the simple average return, and investments with more volatile returns have a larger difference between the two types of averages. If you intend to let your portfolio compound over time, geometric average returns are more relevant than simple averages.

Medians offer another useful return measurement. By definition, half of the data points in a set are above the median, with the rest below. As such, while a small number of extremely high returns may skew an average upward, they will have little effect on medians.

If you buy the small-company universe and capture all the outliers, you can attain the average return. However, investors can't simply buy the universe, but instead must purchase individual stocks. That road is rockier, as shown in the table below.

GREATER SIZE, GREATER CERTAINTY
The returns below reflect averages for rolling 12-month periods from January 1990 through April 2011 for stocks in different market-capitalization groups. We established these deciles by dividing New York Stock Exchange stocks into 10 equal-numbered groups by market value, then slotting all U.S. stocks in our research universe into those groups. The Forecasts draws mostly from the two largest deciles, which have the smallest spread between average and median returns, suggesting a lower likelihood of a given stock delivering returns well below the average.
Total Market
Capitalization
12-Month Total Returns
Dec
No. of
Stocks
% of
total
Stocks
In
Billions
($)
% of
Total
Market-Cap.
Range
---- ($Millions) ----
Simple
Average
(%)
Geometric
Average
(%)
Median
(%)
1
(Large-
Cap)
190
5
10,511
61
17,635
-
403,248
10.3
8.6
8.4
2
(Large-
Cap)
206
5
2,391
14
8,142
-
17,312
12.7
10.8
9.6
3
(Midcap)
217
5
1,300
8
4,534
-
8,099
12.4
10.5
8.4
4
(Midcap)
211
5
783
5
3,018
-
4,528
13.2
11.4
9.1
5
(Midcap)
223
5
573
3
2,156
-
3,015
12.4
10.5
8.3
6
(Small-
Cap)
285
7
507
3
1,439
-
2,153
12.5
10.4
7.2
7
(Small-
Cap)
304
7
351
2
939
-
1,438
12.9
10.8
6.7
8
(Small-
Cap)
383
9
285
2
575
-
933
13.1
10.8
6.3
9
(Micro-
cap)
519
13
209
1
283
-
572
13.2
10.7
3.3
10
(Micro-
cap)
1,551
38
185
1
25
-
283
24.3
20.9
7.6

Slices of the market

To segment our Quadrix universe into deciles based on market capitalization, we divided New York Stock Exchange stocks into 10 equal-numbered groups according to market capitalization. Then we slotted all U.S. stocks in our research universe into those groups, with the small-cap deciles the most populous. Within the deciles, we calculated average and median returns in 244 rolling 12-month periods from the start of 1990 through April 2011.

The decile containing the largest stocks, which today includes companies with market values above $17.6 billion, averaged a 10.3% return with a geometric average of 8.6%. During that period of more than 21 years, Decile 1 stocks averaged a median return of 8.4%. The median is less than two percentage points below the simple average. Decile 2, containing the next-largest group of stocks, delivered a median return of 9.6% — the highest of any decile — and an average return of 12.7%. The spread between average and median return is just over 3%, substantially tighter than those of deciles 3 through 10.

Deciles containing smaller stocks tend to have a greater discrepancy between average and median returns, indicating that most stocks deliver returns well below the average, a trend likely to disappoint many investors who buy five or 10 small stocks in hopes of receiving the average.

Decile 10, containing the smallest microcaps, has averaged a 24.3% return since 1990. The 3.4% spread between the simple and geometric averages, wider than that of any other decile, illustrates the volatility of these stocks. But the median return was just 7.6%, less than one-third of the average return, suggesting that a lot of the decile's outperformance came from a fairly small number of stocks with extremely high returns. If you buy a batch of stocks from that group but miss the positive outliers, you could easily underperform a portfolio of larger stocks.

What it means

Looking for the moral of our story? Here are two:

• While small stocks may as a whole deliver higher returns, individual investors should find fewer dry holes with larger stocks. The table below lists some of our favorite large-caps and midcaps, all of which have Average risk or lower as measured by our Relative Risk ratings. To derive the rating, we consider five measures of risk (volatility, sensitivity to market movements, worst three-month performance, bull-market performance, and bear-market performance) based on 60 months of returns.

• Individual small-cap stocks tend to be riskier than large-caps. So if you intend to fish in this pool, try to improve your odds by diversifying broadly and limiting your portfolio to stocks with strong fundamentals, as evidenced by Quadrix Overall scores. The table below lists some of our sister newsletter Upside's top small-caps and microcaps, all of which earn Overall scores of at least 89. To spread risk, Upside's Best Buy List typically has 15 to 20 stocks.

STOCKS WITH TOP YEAR-AHEAD POTENTIAL
All of the large-cap and midcap stocks below earn Relative Risk ratings of Low, Below Average, or Average. Some of the midcaps and all of the small-caps and microcaps are recommended in our sister newsletter, Upside. To help mitigate the generally higher risk of small stocks as compared to larger stocks, we screened for companies with exceptional fundamental strength, as evidenced by Quadrix Overall scores above 88. Decile 1 contains the largest stocks, Decile 10 the smallest. Upside recommendations are presented in bold.
12-Mo.
Growth
Est. EPS
Growth
P/E Ratio
Quadrix Scores *
Company (Price; Ticker)
Stock-
Market
Value
($Mil.)
Market-
Value
Decile
Sales
(%)
EPS
(%)
Curr.
Year
(%)
5 Yrs.
(Annual.)
(%)
Trailing
Versus
5-Yr.
Median
Versus
Industry
Median
Relative
Risk
Rating
Momen-
tum
Value
Overall
Large-Caps
Exxon Mobil
($80; XOM)
399,718
1
21
58
40
7
11
0.98
0.74
Low
Risk
94
87
97
Apple
($336; AAPL)
314,608
1
71
78
63
21
16
0.71
1.01
Below
Avg.
98
77
99
IBM ($171; IBM)
211,420
1
5
20
15
11
14
1.01
0.89
Low
Risk
68
66
92
J.P. Morgan
Chase ($44; JPM)
175,858
1
(3)
72
25
9
10
0.76
0.51
Below
Avg.
81
94
91
Oracle
($34; ORCL)
174,757
1
42
34
30
15
16
0.79
0.53
Below
Avg.
92
49
89
DirecTV
($49; DTV)
39,284
1
11
51
30
25
18
0.89
0.88
Low
Risk
78
77
97
CSX ($74; CSX)
27,427
1
18
50
27
15
17
1.03
0.79
Below
Avg.
82
58
92
Hess ($75; HES)
25,593
1
9
112
47
11
14
1.24
0.9
Below
Avg.
84
91
87
Aflac ($54; AFL)
25,423
1
12
36
12
13
9
0.61
0.85
Avg.
48
97
84
Altera
($46; ALTR)
15,222
2
57
114
4
15
17
0.81
0.81
Avg.
96
47
97
Midcaps
Advance Auto
Parts ($70; AAP)
5,891
3
9
40
19
12
18
1.12
0.79
Low
Risk
64
68
83
Alliance Data Sys.
($90; ADS)
4,994
3
34
43
21
15
14
0.67
0.71
Average
82
70
96
NASDAQ OMX
($26; NDAQ)
4,699
3
(1)
60
23
14
12
0.85
0.61
Below
Avg.
79
93
94
Amerigroup
($68; AGP)
3,496
4
12
138
(18)
15
11
0.98
0.91
Low
Risk
94
73
99
NewMarket
($173; NEU)
2,400
5
20
12
20
12
13
1
0.8
Low
Risk
86
63
98
Small-Caps
EZCORP
($30; EZPW)
1,501
6
19
33
30
15
13
1.04
1.01
Low
Risk
89
71
99
Diodes
($29; DIOD)
1,368
7
29
113
15
15
15
0.8
0.7
High
Risk
95
77
99
Entegris
($9; ENTG)
1,170
7
46
NM
30
12
11
NM
0.82
High
Risk
95
83
100
Buckeye Tech.
($25; BKI)
1,013
7
17
80
158
8
14
0.92
0.87
High
Risk
78
77
97
DG FastChannel
($34; DGIT)
965
7
27
64
31
20
18
0.64
0.89
Above
Avg.
85
74
99
Microcaps
LTX-Credence
($8; LTXC)
418
9
72
NM
89
20
8
NM
0.59
High
Risk
98
93
99
Vaalco Energy
($7; EGY)
383
9
22
517
23
2
9
0.73
0.3
Below
Avg.
96
83
98
Calamos Asset
($15; CLMS)
304
9
11
43
9
11
15
0.87
0.77
High
64
83
89
Amtech Systems
($21; ASYS)
205
10
213
NM
135
35
9
NM
0.71
Above
Avg.
92
81
98
Metropolitan
Health
($5; MDF)
204
10
4
94
3
10
8
NM
0.4
Low
Risk
86
88
99
NA Not Available.     NM Not Meaningful.     * Quadrix scores are percentile ranks, with 100 the best.

 


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