Small-cap value is the gold ring of investing

Reprinted courtesy of MarketWatch.com
Published: Nov. 18, 2015
To read the original article click here

I think I’m a fairly cautious, conservative investor. But today I’m here to talk about the most potent part of my portfolio; it’s so powerful that sometimes I wonder if I should own more of it.

I’m talking about small-cap value stocks. All the evidence points to one conclusion: For long-term investors, this is the surest way to “grab the gold ring” of investing.

This is the third part of a series on compound interest, which was famously cited by Einstein as one of the wonders of the world. For worthwhile background, you may want to read the first and second columns in the series.

As we saw in the tables in that first piece, compound interest works its magic best when it has lots of time. And small-cap value stocks are ideally suited to investors who can take a long-term view.

Before I get into details, let me say this about small-cap value as an asset class: If in the future these stocks can produce even 75% of their long-term returns since 1928, a modest investment in them can change people’s lives.

For quick review, small-cap value stocks combine the characteristics of stocks of relatively smaller companies (which in many cases, at least in theory, have huge growth potential) with the characteristics of value companies (which typically sell at what could be viewed as bargain prices).

As an asset class, small-cap stocks have a long track record of beating larger-cap stocks. Ditto for value stocks vs. more popular growth stocks. Put these two classes together and you have smaller companies that look like bargains.

What does history say?

To evaluate past performance, the S&P 500 Index is a common benchmark, so let’s start there.

That index, which tracks the 500 largest-cap stocks in the United States, was formally created in March 1957. Since then, the index has compounded at 10.1%, through the end of 2014. Academic researchers have simulated the S&P 500 back to 1928, finding its hypothetical performance to be 10.1% before 1957. (Fine print: These figures don’t take into account inflation, taxes or any management costs.)

With that 88-year history, it may be reasonable to expect future 10% returns for the S&P 500. But I’m uneasy with just making that assumption. For example, in the 15 years that ended Oct. 31, 2015, the index grew at only 4.4%.

Whatever future returns investors get from the S&P 500 Index, I am quite sure that over the long haul they will get more from small-cap value stocks.

Academic researchers say the small-cap premium should be two percentage points above the S&P 500, and the value premium should be another three percentage points.

If that is correct, then small-cap value stocks could produce returns of about 9% in an environment in which the S&P 500 gets 4.4%. In a single year, that would double the benchmark index’s performance. But compounded over long periods, the difference could be very significant.

For example, in 15 years, $1,000 grows to $1,908 at 4.4%, vs. $3,642 at 9%. (That difference is bigger than it looks; a gain of $908 vs. a gain of $2,642.)

That’s theory. In fact, over the past 15 years the small-cap value return was more than six percentages points higher than that of the S&P 500.

I’ve written about small-cap value stocks numerous times. My two favorite articles are this one and this one.

This time I hope to convince you further. And in my next column, I’ll show how small-cap value stocks could potentially turn a single $3,000 investment into $40 million during a single lifetime. No kidding.

Tempering expectations

Let’s look for a moment at some probabilities for future returns. John Bogle recently predicted that the Standard & Poor’s 500 Index will grow at 4% over the next decade. I hope it will do better than that, and in a recent podcast, I decided to compare actual returns over 10-year periods for both the S&P 500 and the small-cap value index.

I reviewed 50 of those periods (obviously with lots of overlapping years).

For the S&P 500, in eight of those periods, the compound return was less than 4%; but there were 10 periods in which the compound return was more than 15%.

For the small-cap value index, there was never a 10-year period with a return of less than 4%. But it had 26 periods (a slight majority of all of them) in which the return was more than 15%.

If you drill down just on more layer in the data, you can see that during the S&P 500’s worst 10-year periods, the average return was a gain of only 1.7%. Ouch. But during those exact same periods, the average gain of small-cap value stocks was 9.2%.

In all 50 of the 10-year periods, the S&P 500’s average gain was 10.1%, just as it was from 1928 through 2014. By contrast, the average compound gain for small-cap value in all these periods was 16.3%.

Despite this really strong history for small-cap value, I’m not sure it’s reasonable to expect returns above 16%. But if the S&P 500 can make 10%, I think it’s very reasonable to think small-cap value can do 12% or more.

I also think it’s reasonable to expect exceptional results more from long periods than from short ones. So I took one more look, this time using historical returns over the theoretical pre-retirement lifetime of a young investor: 65 years. Here’s what I found:

In all the 65-year periods starting in 1928, the average compound return for the S&P 500 was 11.2%; the lowest was 9.7%, the highest 13%. For the small-cap value index, the average was 16.3%; the lowest was 13.1%, the highest 18.5%.

As I said above, I’m a fairly cautious investor. Approximately one-quarter of my equity investments are in small-cap value stocks. Knowing all that I do, I am sometimes tempted to increase my exposure to small-cap value. (If I were younger, that temptation would be stronger.)

When I focus on what I want (higher returns, naturally), small-cap value seems like the asset class that will let me grab that gold ring. When I focus on my needs, I don’t believe I need to stretch my asset allocation.

But for investors with long time horizons, and for those who want to do something potentially spectacular for a child or a grandchild, I don’t know how to beat a long-term commitment to small-cap value stocks.

In my next column, I’ll show you exactly how to do that.

Richard Buck contributed to this article.

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