Small Caps: What You Don't Know But Should

by Raheel Siddiqui, Senior Investment Strategist, Neuberger Berman

Small cap stocks span a wide range of characteristics and performance drivers that we believe index funds are not built to exploit.

More investors are taking a passive approach to small caps, but should they?

Small caps span a wide range of characteristics and performance drivers that even seasoned investors may not fully appreciate. While small cap index funds merely average away those variations, experienced managers, in our view, have the potential to exploit them.

Disparities In Quality

If you split the small cap universe into profitable and unprofitable companies, two extremely different worlds emerge:

• Since 2004, profitable small caps have steadily beaten unprofitable ones by a significant 6.5% per year.¹
• Profitable small caps also appear not as susceptible to market gyrations as investors might think: The median 5-year market beta of profitable stocks in the Russell 2000 Index is only 0.97, while the median beta of unprofitable stocks is much higher, at 1.32.² In terms of risk, unprofitable small caps give the rest a bad name.

We believe higher-quality small caps tend to have meaningfully larger free cash flow (FCF) margins than small caps as a whole. In fact, we find that FCF margins within the top small cap quintile tend to be comparable to those in the top large cap quintile.³

Similar disparities can be found in balance sheet strength, too. We find the 400 most conservative balance sheets among the Russell 2000 are very similar to the 200 most conservative balance sheets within the Russell 1000—though that gap widens significantly when comparing small and large companies that have the most aggressive balance sheets.⁴

Disparities In Growth

Over the past 40 years, the Russell 2000 has delivered average earnings growth of 10% per year. However, we find that the earnings growth of profitable Russell 2000 companies averaged 54% per year versus 3% for the median company in the index⁵—yet another potential opportunity for thoughtful small cap selection, in our view.

Disparities In Value

Small cap equities have been out of favor relative to large caps for more than a decade. A primary culprit for that relative underperformance is the sectoral composition of small caps vs. large caps: Starting in 2014, we find, an investor who chose to underweight the staples, energy, financial and health care sectors while overweighting the technology and materials sectors would have mitigated much of the underperformance of small caps vs. large caps.⁶ Passive investors have to accept these sectoral distortions—active managers do not.

For a deeper dive on the potential benefits of small cap active management, please see “Small Caps: To Index or Not to Index.”

And for a closer look at why we believe small caps are poised to shine in the current environment, please see: “Small Caps: The Next Cycle is Upon Us.”

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