The future of small-cap and value stocks

Reprinted courtesy of MarketWatch.com
Published: Sept 16, 2015
To read the original article click here

Almost every week, somebody asks me if I think the returns of small-cap stocks and value stocks (and also, naturally, the returns of small-cap value stocks) will be as good in the future as they have been in the past.

This is an important question not only regarding these asset classes, but all asset classes. In other words, what does the past tell us about the future?

The simple answer is something like this: I cannot know what the future holds. But I continue to recommend value stocks and small-cap stocks (and yes, small-cap value stocks). And I invest in these asset classes with my own money.

After I give you the evidence on which I rely, we’ll discuss whether that evidence proves anything.

Last winter, I wrote a series of columns discussing the historical performance of various asset classes. These included columns on large-cap value stocks, small-cap blend stocks, and small-cap value stocks.

Here’s the basic set of facts: Over the past 87 calendar years (ending December 2014), each of those three asset classes outperformed the S&P 500 Index. Annualized returns were as follows:

  • S&P 500: 9.8%
  • Large-cap value: 11.2%
  • Small-cap bIend: 12.2%
  • Small-cap value: 13.6%.

That, of course, is all in the past. The future has yet to unfold.

But I don’t believe 87 years of data is a coincidence or accidental. This period includes a major worldwide depression, two world wars, numerous more-limited wars, some long periods of economic expansion and plenty of bear markets and corrections.

One reason I believe in value and small-cap stocks is that I can explain the reasons behind the superior performance of each of these asset classes. In a nutshell, value stocks outperform because they (by definition) can be purchased at bargain prices, while small-cap stocks outperform because, being smaller, they have room to grow. Remember, Apple US:AAPL, Google US:GOOG  and Amazon US:AMZN  were all tiny companies at one time.

In legal terms, that’s the evidence. But it’s not proof. No matter how much evidence I have, I can never actually prove the future. It just can’t be done.

 

People who have read all of my columns ask me how much confidence I have of getting similar returns in the future. Do I really think small-cap value stocks will beat the S&P 500 by three percentage points? I’m reasonably confident in predicting what the next 40 years will be like. But the next six months? Forget it. Even the next 10 years are difficult to predict.

Although I can’t know the future, I do know a lot about the history of stock-market returns.

I have studied the performance of seven major asset classes for every individual year since 1928. I know a lot about what academic researchers have to say about diversification and about investors’ decisions. I have personal knowledge from talking to thousands of investors over the past half century and helping many of them with their investments.

Here, in no particular order, are 13 things I know that give me a sense that I am on the right track when looking at the future.

  1. Future inflation will be significant, but its exact impact is unknown.
  2. If I ignore inflation (a dangerous thing to do), the returns of long-term bonds don’t look horrible: about 7.6% over the past 50 years.
  3. Stocks have a very long history of outperforming bonds.
  4. Higher-risk investments tend to return more than low-risk ones over the long haul. This includes value stocks, small-cap stocks and emerging-market stocks, to name just three examples.
  5. Recurring expenses always diminish investment returns. This gives low-cost index funds a big advantage over actively managed funds.
  6. Investors who move in and out of the market based on news and commentary almost always do worse over time than those who invest wisely and then stay put.
  7. Various asset classes can be counted on to move up and down at different times and different speeds. This makes asset-class diversification a good recipe for a smoother ride.
  8. Past market patterns won’t repeat themselves exactly; there are just far too many economic and psychological variables at work.
  9. Greed and fear will continue to cause many investors to overreact, increasing volatility during turbulent times.
  10. Despite all this, Wall Street will continue to confidently make hopeful predictions. A few of them will come true, but most will not.
  11. Despite all this, the financial media will continue to confidently make predictions of boom and gloom. Taking these predictions too seriously will continue to be harmful to investors’ financial health.
  12. Investment newsletters, needing subscribers, will continue to make provocative predictions that will not be reliable.
  13. Friends, relatives — and even complete strangers — will continue to give advice, usually without any solid base. This advice should not be relied on.

The original question was whether small-cap and value stocks will continue to outperform the market. Based on everything that I know, my answer is that I don’t know, but it seems likely.

I’m investing my money as if the answer to this question is yes. I recommend that you do the same.

Richard Buck contributed to this article.

 

Purchase on Amazon


Sound Investing Podcast