No. of Recommendations: 24
You mention faster growth, but which metrics are you looking at?
I was looking at everything together except the index quotation which will lead you to the wrong conclusion. Main two are revenue growth compared between the two indexes as a proxy for their relative rate of actual value increase (this doesn't work well for stocks but is useful when comparing two indexes), or the total IV increase by means of adding the dividend onto the EPS growth and normalising for margins. It is true that the margin expansion of the S&P500 can be interpreted as part of a sustainable value increase, but I discuss that further below.
In my post I cited revenue growth of the small caps exceeding large caps by 2% over the multi-era long-term, as well as the medium-term (20 years). EPS growth of the small caps was 10% the last 20 years, or 11.5% with the dividend.
If we look at only the very recent period, let's say revenue growth from the start of 2018, not much changes - since 2018 small caps and large caps both grew at the same level of around 52%. There was a big speedup for small caps as covid was coming to an end, and then slow down afterwards, but it averages out. The temporary low margins of small caps, which is fairly often discussed on Wall St when small caps come up is cited as related to the higher debt - however those low margins have already recovered. Margins for small caps sit at 6% today versus their 5% average the last 20 years. So earnings aren't actually depressed at all.
If we look at EPS, and projecting what will happen to EPS from today, I firmly caution that it is less wise to project EPS for the large caps because such a projection requires large cap margins to continue to grow as they have in the past. So for purposes of comparing EPS between two indexes, even if you don't assume any mean reversion at all, you at least have to cancel the requirement that margins continue to expand further from here. That in itself cuts the EPS projection down enormously for the large caps. In short, just use revenue projections when comparing two indexes. Small caps recently grew revenue at the same rate as large caps, over the last 20 years (medium-term) they grew 2% faster, and over the longer term they grew 2% faster.
In summary, all of the perceived outstanding performance of the S&P500 large caps over those 20 years since 2004 is essentially taken from (1) EPS multiple expansion, and (2) margin expansion.
This can very easily lead us to the incorrect conclusion that small caps are in some way inferior companies as a group. This simply does not match the data, even if it sounds natural and intuitive right now. It will have sounded also intuitive in March 2023 when there was a view that they were old-school, and the next 5 years the small caps quotations rose 75% in 5 years versus -15% for the large caps.
Let's look at 1 and 2 and compare the variables between the large caps and small caps, regarding what to expect from today. I mean the two independent variables: (1) EPS multiple expansion, and (2) margin expansion. Keep in mind, in the comments that follow, that small caps are likely to grow revenue at a higher rate than the large caps (S&P500) or at least the same rate. We're just looking at only other two independent variables that lead to the relative outperformance.
For the S&P500 large caps, the first of these (valuation multiple) is very high. The CAPE ratio of the S&P500 is 37 versus 26 average the last 20 years, which is 42% too high. If the multiple merely remains at the current high level without falling, then the rate of change in the multiple will collapse, so stock price returns will be lower than we are used to even if the EPS continues to rise at an average pace we have become used to. But EPS is unlikely to keep rising for another, reason - margins, which gets us to the second variable. For the second variable (margin expansion) we can be optimistic and just assume that they will simply stop continuing to expand. In this optimistic scenario, the *rate of change of margins* over the last decade will fall from the present high positive number down to zero - just to sustain the present margins. This would cause the EPS growth in the large caps to be much lower than we have grown accustomed to observing. So there are two separate downwards forces (multiples, and margins) forces on stock prices for large caps, and one relative upwards force (revenue growth).
For the S&P600 small caps, the first of these (valuation multiple) is at its average level of the last 20 years whether measured by the CAPE ratio of the S&P600 or the one year PE. The forward PE of the S&P600 is 16 today versus, 17 average the last 20 years. I presented a chart of the S&P600 CAPE on the Index Investing board. The CAPE ratio is right in the middle of its own 20 year range for at the S&P600. This PE is itself is based on not particularly high margins, unlike the PE of the large caps which is based on (possibly) temporarily high earns. Now onto margins, small caps are now at 6.5% versus their 5.5% 20-year average.
They [small caps] may or may not be a good class to be in at the moment in terms of forward price returns, and the outlook for the S&P 500 is not great so it may make an easy comp, but I don't think that the historical US small cap results are going to give us a reliable answer on that because things have changed. The biggest issue is the big increase in the share of aggregate value added going to the top 2-3 companies in almost every industry.
This is reflected in, or highly overlapping with, the observation of higher margins today in the S&P500. They key point there is that this advantage has already taken place - margins have already expanded, and can't continue to expand from here at that same rate. To address this question above, one can also ignore the subject of margins, and separately argue that a few mega huge firms, such as Google, will continue to grow at an outstanding rate by having superior abilities to suck up earnings from other firms. However this also doesn't match the data, for the small caps grew revenue at a faster rate than large caps the last 20 years (which view as a medium-term period) which includes the last few years of (at least for now) heightened monopoly-acceptance. Small caps also grew revenue at the same rate as the large caps the last 7 years (obviously with sub periods within those 7 years sometimes higher for one, sometimes higher for the other).
In summary, you can track 3 separate variables - revenue growth, change in margins, and change in valuation multiples, when comparing two indexes. These 3 variables combine together to get the change in stock price. Normally only 1 or 2 of the 3 might win, and the story to be far not determined, but we have a case that 3 out of 3 win for the small caps when looking at what to expect from today.
In short, the small caps feel like lower quality firms (to an investor projecting either the rate of increase in revenue into the future), or an investor projecting the growth in EPS forward into the future), because of the existing narratives and the poor stock price performance. However that intuition does not match the actual data, even when no reversion to the mean arguments are used.
- Manlobbi
