We’ve got a couple of dynamite ideas that may appeal to investors who want to beef up the returns from their portfolios. History shows that over long periods of time, the stocks of small companies have outperformed those of large ones. Small-cap equities are one of the basic building blocks of our Ultimate Buy-and-Hold Strategy, which is based on the idea of investing in passively managed asset-class funds or index funds.

The return premium produced by small company stocks is real, and we expect it to continue over the long haul. The key word here is "long." Small-company investing is productive when you either have many decades or when you are lucky in your timing. But there have been significant stretches of time when small-cap stocks have underperformed large-cap ones. That makes small-cap equities most suitable for investors who have a long time horizon and who use small-caps as only part of a well diversified portfolio.

Let’s look at some historical data. From 1926 through 1969, U.S. small-cap stocks rose at a compound rate of return of 12.1 percent, vs. 9.8 percent for large cap stocks like those in the Standard & Poor’s 500 Index. Those extra 2.3 percentage points might seem trivial, but they make an enormous difference over time. From 1926 through 1969, for instance, is 44 years, well within the potential investment lifetime of many people. In 44 years, $1,000 would grow to $61,165 if compounded at 9.8 percent; but at 12.1 percent, it would grow to $152,281.

Early in 1970, that might have seemed a convincing argument for investing in small-cap stocks. But since then, U.S. small stocks have outperformed their large-cap counterparts by only a hair: 13.1 percent compounded annually vs. 13.0 percent. That’s the difference between a $1,000 initial investment growing to $30,414 (large U.S. stocks) or to $31,544 (small U.S. stocks). Large U.S. stocks had five losing years in that period, vs. eight losing years for small stocks.

If U.S. equities were the only universe open to small-cap investors, the past 28 years could seem pretty discouraging. But small-cap investing works with international equities, too. Since 1970, small international companies have compounded at a rate of 17.5 percent, vs. 15.6 percent for large international companies. That’s the difference between $1,000 growing to $57,919 (in international large stocks) and to $90,923 (in international small stocks).

You can see the year-by-year details in the table on Page 4. But the real question is what to make of this. Let’s tackle two questions. Is there some reason that small-cap stocks outperform large-cap ones, and is that reason likely to persist in the future? And do the figures suggest a strategy for small-cap investing?

First, the small-cap rationale. In general, investors get paid for taking risks, especially taking prudent risks. As you can see from the worst-period and standard deviation figures in the table, small-cap stocks are riskier than large-cap stocks, though the effect has been much milder with international issues than with domestic ones. Small-cap stocks are riskier because they are generally newer companies. They are the Yahoos and the Amazon.coms of the world rather than the IBMs and the General Electrics.

A large, mature company has already proved it can survive competition and economic storms. An upstart can fall on its face, and many do. These smaller, newer companies can produce higher returns because they can grow faster. A Microsoft in 1987 could grow much faster than it can in 1998. A relatively new Internet company or a computer hardware manufacturer like Iomega can grow much faster than a Kodak or a Sony, which are already huge.

We don’t see any reason to think this basic relationship will change. We believe small companies will continue to be riskier than large ones. And we believe that over long periods of time investors in small companies will be rewarded with higher returns. But over shorter periods, we believe small-cap investing will continue to be challenging because returns will vary so much from year to year.

Second, does history suggest a strategy for successful small-cap investing? Yes. Look at the table on Page 4 called "Small-cap investing." You’ll see year-by-year returns for U.S. small-cap stocks (Option 1) and international small-cap stocks (Option 2). For each of these, we’ve calculated the year-by-year progress of a hypothetical $1,000 investment made at the start of 1970. You’ll see that $1,000 grew to $90,923 in international small-cap stocks, but only to $31,544 in U.S. small cap stocks.

You’ll also see the returns you would have received from an investment split 50/50 between U.S. and international small-cap stocks from 1970 through 1997, with annual rebalancing (Option 3). That global diversification would have smoothed out the peaks and valleys of annual returns and reduced the worst-period risks of investing in either U.S. or international small-cap issues alone. This 50/50 blend assures an investor will get some of the benefit each year from whichever sector, U.S. or international, outperforms the other. For instance, in 1977 you might have been happy with the 26.8 percent return from domestic small companies. But a balanced portfolio would keep you from missing out entirely on the dazzling 74.1 percent return from international small companies that year. You’ll see other striking single-year contrasts. For example, check out 1972, 1979, 1987 and 1995.

Note also that the total return from this combination was significantly more than the average of the returns of either Option 1 or Option 2 alone. Rebalancing once a year is a way to keep the risk of an investment portfolio in check. For example, if you invested equally in indexes of U.S. and international small companies in 1970 and never rebalanced, by the end of 1990, 92 percent of your portfolio would be in international small stocks and only 8 percent in U.S. small stocks. Such a portfolio would carry substantially higher risks than the 50/50 allocation you started with. And you can see from that table that in 1991, 92 percent of your portfolio would have risen by 7.1 percent while only 8 percent would have received the benefit of the 44.6 percent gain of U.S. small companies.

Before we start exploring a couple of possible strategies for successful small-cap investing, I want to emphasize how challenging this market segment is. Over this 28-year period, $1,000 invested in Option 2 would have experienced seven losing years, with an average loss of 15.1 percent. With Option 1, U.S. small-cap stocks, there were eight losing years with losses averaging 15.5 percent. In four of the 28 years, both Option 1 and Option 2 lost money. Annual rebalancing, by the way, would have cut the number of losing years to six and the average loss to 14.3 percent.

We have the benefit of seeing final results of these options in this table. But the only way to achieve those results was to experience the investments one year at a time. And one year at a time, the results look wildly inconsistent. Investing equally in U.S. and international small stocks and rebalancing once a year is a prudent, easy way to take advantage of small stocks’ higher returns.

But I see something else in the numbers, a pattern that suggests a possible strategy that would have worked well in the past and might work in the future. Before I share this with you, I have to confess that the strategy I’m about to outline is very aggressive and carries above-average risk. It violates an unofficial rule against something called "data-mining." That phrase means using the benefit of hindsight to study historical data and extract bits and pieces of information that conveniently fit into some philosophy or some notion of reality. Academic researchers would be quick to tell you that conclusions you draw from data-mining are invalid and unreliable guides to the future.

So please don’t bet your financial future on what I’m about to share with you. At best, the strategy I’m outlining would be an interesting experiment suitable for a small part of the portfolio of somebody with a long time horizon, say 15 years or more. Ideally, this strategy would be undertaken in a tax-sheltered account such as a Roth IRA. With that warning, let’s look again at these 28 years of annual small-cap returns.

If you could invest in small-cap stocks with the benefit of hindsight, you’d want to have your money in whichever sector, U.S. or international, did the best each year. In 1970 through 1974, for example, you’d want to be in international, then switch to U.S. in 1975 and 1976 and switch back to international in 1977, and so on. With 20/20 hindsight, you’d have your small-cap investments in the "winning" sector each year, for an average return of 32.7 percent and only four losing years. But such hindsight is obviously impossible, and there’s absolutely no way in the world you could have made such a string of investment decisions short of pure luck.

So is the attempt to maximize your returns from small-cap investing nothing but a crapshoot? I’m not so sure. To see why I think that, take a look at the table and in the columns for Option 1 and Option 2, underline the higher return of each calendar year. When you’ve done that, you’ll see that whichever sector (international or U.S.) was more successful seemed to continue its success for more than one year at a time. In fact, the success of one sector over another seems to follow some series of trends that persist for anywhere from two to seven calendar years. And that persistence of trends is the core of what I’m going to suggest.

If you believe the returns in the Option 1 and Option 2 columns from year to year are just random and that superior performance shifts back and forth between domestic and international small-cap sectors purely by chance, then the strategy I’m about to outline makes no sense for you. But I believe there are reasons that U.S. small-company stocks do better than international ones in some years and worse in other years. I don’t have to understand those reasons in order to see that I can take advantage of trends. And at least in this 28-year period, I can see that there’s a better-than-even statistical chance that whichever sector was the "winner" in one year was also the "winner" in the following year.

Now imagine that you had been armed with that notion in 1970 and you decided to adopt the following simple strategy: At the start of each calendar year, put all your small-cap investment money into international or domestic, whichever had better performance in the year just ended. Then repeat the process the following year. This simple switching strategy, which you will see in the table as Option 3, is easy to understand and easy to implement. We were frankly amazed how productive it was, turning a $1,000 investment at the start of 1970 (splitting your money equally between U.S. and international small-cap stocks for the first year because we don’t have reliable data from 1969), into $247,060, with a compound rate of return of 21.7 percent and an average return of 25.3 percent.

To put that into perspective, a $1,000 investment in the Standard & Poor’s 500 Index in the same time period would have grown to $30,414. And $1,000 invested in a global balance of U.S. large, U.S. small, international large and international small companies, rebalanced every year, would have grown to $58,733.

Do I recommend you abandon your current investments and bet everything on this small-cap strategy? No way! But I think this strategy has some merit for small-cap investors. Personally, I’m inclined to suggest you be a little more conservative and put only 75 percent of your small-cap money each January into the sector that outperformed in the previous year. In the table this is Option 5. That way, in years (like 1997) when one sector is up strongly and the other is down sharply, you will have at least some of your money in the strategy that’s gaining and you won’t have all your money in the one that’s lagging. Option 5, by the way, nearly doubled the total return of Option 3, producing the same number of losing years (six) and a compound rate of return of 19.3 percent.

Like the models we use for timing markets and individual funds, this is a trend-following strategy. Its success is built on the simple premise that a trend (in this case, last year’s performance) is more likely to continue for another year than it is to reverse course. While our market-timing models and fund-timing models are more complex, they are based on the same premises: that real trends exist (in other words that performance is not purely random), that those trends can be identified while they are occurring (in other words in time to act on them) and that they often persist long enough after they are identified that investors can capitalize on them.

If you’d like to put this information to work in your own portfolio, it’s best to do so in a tax-sheltered account. A Roth IRA would be ideal, because the gains could escape taxes permanently. We also suggest you use the no-load mutual funds in our Model Portfolios. For U.S. small-cap investing, consider Vanguard Index Small-Cap Stock Fund, Schwab Small-Cap Index Fund or the Fidelity Small-Cap Stock Fund. For international small-cap investing, consider either Fremont International Small Cap or Founders Passport Fund.

Just as a final thought, consider that the returns in the table resulted from a single $1,000 investment. If an investor had added $1,000 at the beginning of each calendar year for 14 more years, small-cap stocks could have turned that $15,000 total outlay into $414,125 with Option 1, $496,894 with Option 2, $548,974 with Option 3, $919,478 with Option 5 and $1,411,697 with Option 4, the most aggressive strategy here. For comparison, the Standard & Poor’s 500 Index would have grown to $317,691.

 

 

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