How to understand the small stock rally

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So far this year, small stocks have beaten their large-cap brethren many times over than in more than two decades, raising questions about what drives outperformance and what that means for the overall market to come.

The year-to-date return for small caps through the end of February was a respectable 25 percentage points higher than that for large caps (measured by the 20% of stocks with the smallest market capitalizations compared to the benchmark quintile of the largest). While it is not unexpected for small-cap portfolios to outperform large-caps over time – a long-term trend that Wall Street analysts refer to as the “size effect” – the extent of outperformance is unusual. According to Ken French, a professor at Dartmouth, the average has been just 0.9 percentage points for all two-month periods since 1926.

You have to go back to January and February 2000, at the top of the internet stock bubble on Wall Street, to find a two month stretch where small caps outperform large caps. Their outperformance in these two months was 41 percentage points.

Any parallel to the top of the internet stock bubble is ominous, of course. However, there are a few specifics about recent small-cap performance that stand in the way of a clear analogy to the small-stock frenzy that heralded the crash of tech stocks in 2000.

In fact, according to several researchers, the recent strength of small caps might actually be something else – that is, it might have to do with factors other than just size, like the battle between growth and value stocks.

That doesn’t mean there is nothing to worry about in this bull market where valuations are thin for many stocks. However, this means that investors focusing solely on the small-cap / large-cap divergence may overlook the bigger picture.

Here’s why.

1. Value versus growth

One distinction that’s critical to understanding the relative strength of small caps this year has to do with where small and large cap stocks fall on the spectrum of growth and value. Small-cap stocks are currently much closer to the end of the spectrum than large-caps, which means they trade at lower prices relative to their net worth.

Small outweighs big

In Russell indices, performance increases as you lower the market cap scale. Since December 31, 2020:


A share’s place in this spectrum is defined by the ratio of price to book value per share, with the highest ratios on the extreme of growth and the lowest on the extreme of value. Take a look at the Russell Microcap Index, which contains the smallest 1,000 stocks in the Russell 3000 index for the broad market. According to Russell Indexes, the average price-to-book ratio at the end of February was 2.5. This is comparable to a rate of 4.2 for the Russell 1000 Index (which contains the largest 1,000 stocks) and a rate of 5.7 for the Russell Top 50 Mega-Cap Index (which contains the largest 50 stocks).

These are significant differences, according to Kent Daniel, professor of finance at Columbia University and former co-chief investment officer at Goldman Sachs. He says that, on average, small-cap growth stocks tend to lag the market, while small-cap value stocks tend to lag behind tend to outperform. Since 1926, the smallest capitalization stocks closest to the growth end of the spectrum have lost 3.3% on an annualized basis, while the smallest value stocks have gained 13.3% on an annualized basis.

This pattern has been particularly strong in recent months, making it difficult to determine what constitutes the relative strength of small caps this year. But Prof. Daniel says there is a clear possibility that it is actually a “value effect that disguises itself as a size effect”. If so, a bet on the continuation of the relative strength of small caps is really a bet that value will outperform growth.

That bet could pay off in the months ahead, and the value could outperform growth over many years. But he also says that value stocks have lagged behind growth stocks for at least a decade, and while there have been numerous predictions of a recovery in value during that time, that hasn’t happened – at least not yet.

2. Sector bets

The benchmark indices for small and large caps have different sector weights, which also makes it difficult to assess whether the recent relative strength of small caps is actually due to company size.

Angled sector bets

Current portfolio weighting by sector

IWM: iShares Russell 2000 ETF

IWC: iShares Russell Microcap ETF


XLG: Invesco S & P 500 Top 50 ETF

Health care



Discretionary discretion for consumers

Information technology

Real estate


Consumer staples




Look at the information technology sector. The ETF compared to the 50 largest stocks currently has a 38.6% weight for the sector, more than three times the Russell Microcap Index’s weight of 12.7%.

Conversely, the Microcap index has more than ten times the weighting of the largest ETF with 50 stocks in the industrial sector (11.7% versus 0.8%) and more than double the allocation in the financial sector (17.6% to 7.1% ).

These disparities are a large part of small cap performance since the beginning of the year, as industrials and financials each outperform information technology. For the 2020 calendar, it was exactly the opposite, with the smallest stocks lagging behind the largest of last year.

Until there are small-cap and large-cap benchmarks with the same sector weighting – Prof. Daniel says he doesn’t know of any right now – it will be difficult to determine what drives the relative strength of small stocks. However, if this is due to differences in sector weights, it is only likely to persist if the sectors where small caps are overweight continue to outperform.

3. Is the small cap effect real?

This discussion also points to a more fundamental question that many researchers have asked themselves in recent years: Does the small-cap effect even exist in and of itself? In other words, do smaller companies really have higher returns on average than larger companies over long periods of time?

Andrea Frazzini, principal at AQR Capital Management and associate professor of finance at New York University, has concluded that it only exists among a very narrow group of stocks. He says some of the relative strength of small caps in recent months has been due to speculative fervor for stocks outside of that narrow group, making it risky to bet it will continue.

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According to his research, small caps are a good choice to outperform large caps only if you focus on companies with high financial quality. He understands financial quality to include companies that are profitable, have robust earnings growth and a stable income stream, and have a high dividend payout policy. Many of the small businesses that have performed the best so far this year do not qualify.

Companies that have received a higher bid in the past few weeks through social media investor campaigns like GameStop GME 4.07%

and AMC Entertainment AMC 0.25%

– are two obvious examples, but they are hardly alone when it comes to failing to qualify for Prof. Frazzini’s high-quality category. For example, almost half of the 2,000 companies in the Russell 2000 Small Stock Index lost money in 2020.

Prof. Frazzini’s research therefore suggests that if you are looking to continue the recent relative strength of small caps, you should focus on small stocks that score high on various measures of financial strength, security, and quality . And don’t sweat the comparisons with the internet stock frenzy of 20 years ago.

Mr. Hulbert is a columnist whose Hulbert Ratings tracks investment newsletters that pay a flat fee for the exam. He can be reached at

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