The Investment Scientist

Posts Tagged ‘large cap growth

ImageIf you are a typical investor, given the choice between investing in a small cap value fund or a large cap growth fund, which one would you choose?

You would probably go with the large cap growth since “large cap” sounds a lot safer than “small cap,” and “growth” sounds a lot more promising than “value.”

To prove how wrong you are, I did a study of the relative performances of these two styles in the eight decades between 1931 and 2010. Here is what I found.

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If you invested $1 in the small cap value index at the beginning of 1927, you would have had $52,892 by the end of 2010. This is according to the recently published Dimensional Fund Advisors’ annual Matrix Book. Included in the book are historical risk and returns of various indices based on capitalization and book-to-market valuation.

Table 1 presents a summary of historical returns. The best returns are marked in green; the worst, marked in red. As one can see, the small cap value index is the best for all the periods considered. And it is the best by a huge margin.

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July 2008 marks the start of a bear market after all major market indices have fallen more than 20% from their most recently peaks. This article is part two of my three-part research on bear markets. In part one, I researched how long a typical bear market lasts?. In this installment I ask this question:

Which style fared the best in a one-year time frame after stocks have entered a bear market?

There are four primary styles of stock investing: Small Cap Value (SV), Small Cap Growth (SG), Large Cap Value (LV), and Large Cap Growth (LG). Typically, before stocks enter into a bear market, Small Cap stocks, regardless of value or growth, get hit the hardest.

Using data provided by Fama/French benchmark style portfolios, I calculated one-year returns of the four investment styles from the month stocks entered a bear market. The results are tabulated below.

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Confusing volatility and risk could cost you a bundle. Let’s take a look at returns on an investment of $1000 over 50 years from 1958-2007 in five asset classes.

  • Small cap value: $3,750,000
  • Small cap growth: $81,200
  • Large cap value: $854,000
  • Large cap growth: $130,000
  • CD: $13,800

Isn’t it obvious which is the best long-term investment?

Why small cap value is the best long-term investment

So you don’t have a 50-year investment horizon? Few of us do. How about a ten-year horizon? In any ten-year period from 1958 to 2007, small cap value had much better investment results than a “safe” CD. (See Table below. Green = best result in the given ten years; red = worst.)

Table: How would $1 investment become?

    10 year periods Small Cap Growth Small Cap Value Large Cap Growth Large Cap Value CD
    1958-1967 $5.64 $8.02 $3.22 $5.39 $1.36
    1968-1977 $0.97 $2.66 $1.2 $2.64 $1.75
    1978-1987 $3.38 $7.84 $3.52 $4.96 $2.41
    1988-1997 $2.87 $6.47 $5.38 $5.13 $1.7
    1998-2007 $1.53 $3.47 $1.77 $2.36 $1.42
    Annual volatility 28.23% 24.05% 17.67% 18.54% 1.7%

Safety paradox

Even though a FDIC guaranteed CD is perceived to be safe, over time, inflation eats away at returns. For the long-term investor – and by that we mean you – small cap value is less risky.

Why do few investors put their long-term investment in small cap value? And, when the going gets rough, why do many small-cap-value investors switch their money to CDs?

Here’s why, small cap value is highly volatile (See last row of Table) and volatility makes us anxious and jumbles our judgments.

Volatility does not measure risk.” -Warren Buffet

Volatility becomes risk only when the investor can’t stand it anymore, and abandons an otherwise safe long-term investment. Typically, volatility is highest and its impact most painful when the market reaches bottom. Not surprisingly, many investors bail out at the worst possible time.

Upon learning that he had to sail by the Sirens – the creatures whose beautiful songs could lure him to jump to his death – Odysseus asked his sailors to tie him to a mast. What mast do you tie yourself to?

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Portfolio review – uncover problems, avoid losses.

small-cap-value-return-minus-large-cap-growth-return.gif

By the end of 2006, Small Cap Value stocks had completed a historical 7 year run of outperformance relative to Large Cap Growth stocks. According to Prof Kenneth French’s data library, during this 7 years, Large Cap Growth returned a total of -10.35% while Small Cap Value returned a total of 266%!

2007 however saw a drastic reversal. In the first 10 months alone, Large Cap Growth has outperformed Small Cap Value by a whopping 18%! If you are a Small Cap Value investor and you are nervous, you are not alone. How much longer and how much more will Small Cap Value uncerperform? To get a handle of these issues, it is helpful to get a historical perspective.

Based on the data on Fama/French benchmark portfolios in Prof. French’s data library, and by comparing the yearly performances of the Small Cap Value portfolio and the Large Cap Growth portfolio since 1960, I obtained the following results:

1. 75% of the years, Small Cap Value outperformed; 25% of the years, Large Cap Growth outperformed.

2. $1000 invested in Small Cap Value on 1/1/1960 would grow to $1.7mm on 12/31/2006! In comparison, $1000 invested in Large Cap Growth on 1/1/1960 would grow to only $66k.

3. There are 8 occurrences of Large Cap Growth outperformance. 3 lasted for one year, 3 lasted for two years and 2 lasted for 3 years.

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.

Twitter: @mzhuang

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