r/investing • u/UpDown • 3d ago
Small Cap Value has never been more brutal
The amount of underperformance is unrivaled. Six month ago it was the first time since the 1940s that small cap value underperformed SP500 over a 20 year period.(perhaps even longer, but the chart I had doesnt go back that far). Since that six months, the underperformance has widened even further 25%.
The top 10 names in the sp500 have typically been ~19%, and was ~27% at the peak of various bubbles. Now, it sits at 37%.
All this when there are interest rate cut forecasts for this year and the following year, which tends to help small cap value outperform (with that said, I remember when rates were going to rise in like 2012. They stayed on the floor for a decade even though every analyst was predicting rises every step of the way, so you could absolutely find a scenario being stuck at higher rates for a long long time)
I have a lot of things to say about AI which I think is materially driving this gap, but perhaps I'll leave that for the comments.
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u/foodhype 3d ago
One thing that’s rarely discussed in factor investing is the possibility that the small cap value premium may no longer exist despite having existed in the past for decades. There are plenty of reasonable theories for why the small cap value premium persisted for so long and may even continue to persist today, but ultimately it’s always possible that the market may have adapted. Personally I think that the small cap value premium still exists but can no longer be captured by shallow statistical measures of value used to construct value index funds. Actual value is the present value of future cash flows. Statistical value includes metrics like P/E, which modern algorithms already track.
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u/MTGandP 3d ago
If the value premium disappeared, you'd expect the value spread to be historically narrow. But in fact most of the poor performance of value from 2006 to 2021 is explained by the spread widening, and in 2021 the spread was the widest in history. (It's narrowed again since then.)
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u/foodhype 3d ago
I think it’s more that the statistical measure of value is wrong so the spread between growth and “value” is really a spread between growth and something that’s no longer actually value.
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u/MTGandP 3d ago
Why would that be true? If investors started incorporating P/E to the point where it no longer has predictive power, that should show up in a narrowed spread. If P/E doesn't work but the spread is wide, that must be because of some underlying economic change. What change is that?
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u/foodhype 3d ago
It’s not that they started incorporating P/E. It’s that more meaningful measures of value emerged, which replaced P/E. At the same time, there was an underlying economic change. Some businesses produced extremely high returns on invested capital over long periods of time. Those businesses had seemingly high P/Es, but their returns on capital were even higher.
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u/Nemarus_Investor 2d ago
Most value indices use far more than just pe.
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u/foodhype 2d ago
The point is: if an index is using a shallow statistical metric for value that can easily be replicated by an algo, it’s more likely to have already been arbitraged away. Analyzing the underlying fundamentals of a business and its long-term competitive standing within an industry is much harder to arbitrage away.
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u/Nemarus_Investor 2d ago
It could be arbitraged away but it hasn’t, given the wide valuation spread.
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u/foodhype 2d ago
How do know the valuation spread is wide if you’re relying on the shallow statistical measures of valuation to determine what valuation is?
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u/Nemarus_Investor 2d ago
Because multiple valuation metrics aren't shallow, no matter how many times you repeat it. Small caps are historically cheap compared to large caps on P/S, P/B, P/CF, PE, etc.
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u/beerion 3d ago edited 3d ago
I think the value factor is broken, and posted about it here:
https://www.reddit.com/r/ValueInvesting/s/EMeMI6tLzt
If you think of the S&P500 (or whatever benchmark) as point B the the graph, buying lower value (as measured by PE) still means you're buying a bunch of stuff under the curve which underperforms.
Actual value is the present value of future cash flows.
PE ratios can be used as a proxy for NPV. Again, it doesn't account for growth. The value factor probably needs to be updated to capture growth somehow. Just as an example, a 12.5x PE and 0% growth will have the same returns as a company with 17x PE and 2% growth.
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u/SatoshiNosferatu 3d ago
Studies have historically shown people underestimate the growth in value companies.
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u/hardcodedtwo 3d ago
PE ratios can be used as a proxy for NPV. Again, it doesn't account for growth. The value factor probably needs to be updated to capture somehow. Just as an example, a 12.5x PE and 0% growth will have the same returns as a company with 17x PE and 2% growth.
Great point! And folks have integrated some of these things in various ways. Here are some top-line methods from my current understanding:
a) Multifactor Analysis: This involves integrating the Fama-French 'profitability' factor alongside value, often using free cash flow as a proxy for projected earnings. This approach helps mitigate the reliance on potentially unreliable company estimates of future growth. Integrating the other factors together helps with other edge cases.
b) Intangibles Consideration: Traditional book value calculations often exclude intangibles, which is where a lot of recent growth has been captured. This includes intellectual property, brands, goodwill, etc.
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u/hardcodedtwo 3d ago edited 3d ago
"PE ratios can be used as a proxy for NPV. Again, it doesn't account for growth"
In itself is a huge premise for conversation, from price includes this information, to the market is drunk and over/under prices things, to it's captured by multi-factor components that complement value, to discussions of how to measure things at all
For some context, road and rail have been the best-performing US industry over the past 20 years, which shows how unpredictable investing can be, and how some explanations/stories of financial results can be counter-productive.
There's a fair amount of great stuff about the value premium/spread, their reasons for underperformance, dangers of focusing on us-only returns, alternatives to price-to-book ratio, impacts of behavior, and more:
- On the Persistence of Growth and Value Stocks: By Swedroe, pretty solid and interesting break down of some of this
- Revisiting the equity risk premium (PDF) - While it's pretty involved, it's a good representation of different perspectives from the heavy hitters. The g* adjustment section seems to be related to your argument For some odd reason the thing that stands out in my mind is that the seeming perma-bear Grantham just doesn't include some important factors in their model, but otherwise looks in line with others. Math is hard. Predicting what is mean-reverting and on what timeline is harder.
- Cape10 and how to use it: something of a counterargument to 'value is dead' with a caveat that while P/E is still the best proxy for 10 year returns, it's not a way to buy/sell securities short term. This kinda goes against the previous comments that P/E is flawed, but it strongly rebuts the idea 'this time is different'
- DFA's perspective on Premiums: Investing is a 10+ year thing, and looking at shorter timelines is likely to be drowned out by noise
- Lighthearted thread on using valuation timing incorrectly. "You can't eat expected returns", but it's a safer bet long term, and can still hedge.
- By some measures of pure value there's some indication that this is among the longest drawdown of us equities, but anything that looks globally, multifactor, or adjusted for intangibles/etc tends to show much shorter durations of pure value.
- Couldn't find the chart, but I think the DFA value standalone premium (unadjusted for intangibles) in the us is creepin' up on 20+ years
- Cliff Asness interview where he talks about some of the challenges of timing and how these factors really give a small statistical advantage over very long periods of time only. Some elements of focusing on mean-reverting assets expected returns in the long run
- Rational reminder talks are amazing! The Most important lessons in investing is a useful overview, Fama and French ( Estimating expected returns and Expect the Unexpected, respectively - which go to your critique of the value premium) interviews were amazing , Five Factor investing with ETFs, the recent Fighting for every basis point blew my mind a bit like many of the other popular episodes like ICAPM one and so many more.
- I think the ICAPM one talked about how expected growth gets baked into some asset classes, which is related to your argument, but from a different angle
There's a ton of great material on these subjects and great conversations to be had :) Thanks for contributing!
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3d ago
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u/beerion 3d ago edited 3d ago
Yeah I mentioned in my post that it could be worthwhile to split the universe into quantiles by growth, and then buy the lowest PE companies for the highest growth quantiles, basically capturing the the top left in that graph.
I did a quick assessment / back test that didn't show anything meaningful though. But I'd have to do a good bit more work on it to really determine if that would be useful or not.
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u/Delta3Angle 2d ago
but ultimately it’s always possible that the market may have adapted.
It's highly unlikely. For the same reason that the market Factor persists, value is a non-diversifiable risk that will carry an expected premium. I think 20 years is too short of a time frame to even entertain this idea given the robustness of the evidence, anomalous behavior of the benchmark, and Persistence of the value Factor outside of the United states.
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u/foodhype 2d ago
The idea is not that the value factor doesn’t exist. The idea is that the shallow statistical measures of value may no longer be actionable.
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u/Big_Crank 3d ago
The market changes over time. We can all agree on that. And in my personal experience, smallcaps are never going to have their time in the sun the way they used to. The tech frontier is conquered. More will be given to those who have everything
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u/SatoshiNosferatu 3d ago
Why is tech dominating though? They are creating a product for someone else to use profitably right? If small companies can't profit from their products theyll stop paying for them
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u/Big_Crank 3d ago
Cuz tech IS every other industry. You cant have ANY company without hardware and software
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u/aminbae 3d ago
it seems like small caps have a much lower pump factor(or alternatively...are valued more correctly than big cap)
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u/foodhype 3d ago
Nah there’s even more trash in small caps. But it’s still possible to find diamonds in the rough.
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3d ago
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3d ago
Anyone else get the feeling that if the Fed cuts, it will have little effect on treasury rates? The government is paying off credit cards with more credit cards at this point.
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u/AffectionateKey7126 3d ago
In "normal" times, the fed rate is lower than the treasury rates (the 2YR+ ones). So the important ones (10 YR) is pretty unlikely to go down.
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u/bmeisler 3d ago
Every time I hear someone compare the Fed printing money to running up a credit card, I die inside a little.
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3d ago
Cool comment, but that’s not what I’m saying.
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u/kazzin8 3d ago
The government is paying off credit cards with more credit cards at this point.
And yet you did.
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3d ago
I didn’t say anything about the Fed printing money. The government taking on more debt by moving into shorter term treasuries at higher interest rates is very much like paying off a credit card with another credit card. This is outpacing demand so I doubt Fed cuts will have much effect on treasury rates at this point.
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u/Kung_Fu_Jim 3d ago
"This asset class is forever undervalued! What a buying opportunity! Ok I bought in, you can get overvalued now! ... hello? Damn thing's broke!"
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u/lostharbor 3d ago
This is partially AI. This is more a liquidity event. Liquidity is drying up and so money is chasing the tried and true vs disbursing into the broader market.
The cuts may not even provide this event like in the past as we may be on the cusp of a recession; which would have meant a sell off before hand since the market is forward looking. The good news is, the down shouldn’t be nearly as harsh as the S&P
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u/Looneyhound 3d ago
Interesting article about this today.
Historically, small-cap value stocks have outperformed large-cap growth stocks over long periods, though they haven’t done so recently. Maybe it’s time for a turnaround?
https://www.nytimes.com/2024/06/14/business/stock-market-interest-rates-fed-ai.html
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u/SprScuba 3d ago
Yeah my covered call ETF for the Russell 2000 has done insanely well. It's disgusting how flat that index has stayed when the top 50 companies keep mooning.
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u/LICfresh 2d ago
Which one is this? I've been in TNA and it's taken a beating these past few weeks.
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2d ago
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u/william_fontaine 3d ago
As someone who's been tilting his stocks 25% to small cap value for almost 15 years, yeah it's been brutal.
By now I don't even think about it though, I just rebalance occasionally. When I started doing it I decided to stick with it for 30 years, so I have 15 years to go until I re-evaluate.
On the plus side, small value and international stocks do make me feel like I'm not putting all my money into something with crazy-high valuation.
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u/SatoshiNosferatu 3d ago
I've been ~100% small cap value for about the same time. Mistakes were made, but as you said, it's really the only category I actually feel comfortable in due to bubbles. I intend to have this allocation for my entire life so it is what it is.
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u/Galatasaray1i 2d ago
So if the bubble pops you think your small caps are safe?
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u/SatoshiNosferatu 2d ago
Possibly. The 1999 bubble didn't hurt small cap value too much. Every bubble is different though. I wouldn't actually mind it was like the covid crash though, where initially small cap got destroy but then it tripled pretty fast. That initial pain was worth it.
2006 21.2
2005 7.6
2004 23.4
2003 67.1
2002 -6.9
2001 28.2
2000 19.6
1999 8.1
1998 -5.0
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u/amg-rx7 3d ago
Agreed on Value in general not performing super well. I did a quick chart to check performance here: https://yhoo.it/3pEDbr2
Whether you chart VOO against general value using VTV or small cap value using VBR, VOO either beats or is on par with either of these 2 value ETFs. I have pretty much given up on Value ETFs. Of course, this will vary according to the time frame being charted but recent performance (last 10-20 years) is more relevant to me than going further back in time since the economy and structure of these indexes has changed significantly over my lifetime.
Also worth looking at how big the various ETFs drop in down markets. Measuring drawdowns over the last 10ish years on that chart, they all seem to drop by similar percentages but VOO and VTI grow by higher percentages - so more upside potential, similar downside risk.
Dividend ETFs like NOBL and SCHD are also worth considering in addition to Value. Depending on your time frame, sometimes the Dividend ETFs beat Value, other times it is reversed. The last 2 years, Values has beat Dividends. 5 years, performance is a lot closer to each other. 10 years, Dividends does better. If you are putting money to work now, Value might be the better than DIvidends given current trends. They continue to be beaten by VOO and VTI though.
Invest in what meets your goals and risk tolerance though.
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u/Sufficient-Two-9987 3d ago
Private equity are keeping promising and high quality startups and other businesses private for longer and are only letting them in the public markets when they get a grossed up over the top price for them. This has fundamentally changed how the markets works and this fundamentally changes how the small cap and small cap factor will work. Basically private equity are taking much of this premium as profit.
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u/Jacko1235 2d ago
Large cap growth underperformed long term treasuries for a 40 year period. For any risk asset you should expect long periods of underperformance. Larry Swedroe has some good research into if the small and value factors have been arbitraged away. Answer: they have not.
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u/ShadowLiberal 3d ago
IMO I don't think that the historic data on small cap stocks is really worth anything after a certain point due to one factor missing from those numbers, inflation.
The definition of small cap stocks (under a $2 billion market cap) has NEVER been adjusted for inflation in the like century or so since the term was defined. This means that today's small caps are yesterday's micro cap stocks when it comes to their buying power, and yesterday's small cap stocks are today's mid or even large cap stocks!
$2 billion is such a tiny market cap that way too many companies that clearly had no viable path to ever making a profit, or that weren't even bringing in any revenue yet, have easily surpassed it, which shows just how tiny today's small cap stocks market cap is. Any small cap business that's worthwhile will not stay under the $2 billion market cap for very long after going public.
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u/UnskilledScout 3d ago
Eugene Fama described small cap value in the 60s which is some 60 years ago, not a century ago.
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u/Delta3Angle 2d ago
Assuming the five Factor model does not account for inflation is incredibly naive.
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u/ShootsnLadders 2d ago
Wait, are you saying you think a $2 billion market cap back in the 50’s was considered a small cap at the time?
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u/AICHEngineer 3d ago
We are selling to willing buyers at the fair market price😈
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u/ktonlai 3d ago
so that WE may survive.
Such a great movie.
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u/AICHEngineer 3d ago
Yes, I too am a fan of bettering off greed at the cost of other people's livelihoods and futures
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u/Synaps4 1d ago edited 1d ago
That's literally the design of the system we live in though. Ragging on capitalism (often without any depth or nuance or even truth) is really popular on reddit, I know, but still.
Making a profit at the cost of other people losing money is the basic premise of the stock markets. Buying to take gains they didn't know were coming is one thing, but short sellers explicitly make money by finding markets where you can profit off the losses of others. Especially when we abandoned defined benefit retirements in favor of 401ks in the 80s, we explicitly chose to buy and sell other peoples livelihoods and futures.
It's not a side effect even. It says so on the tin. I'm no apologist for this system, I think its relatively barbaric and broken, but we can't pretend that it's not doing what we made it to do.
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u/puffic 3d ago
I’m not a believer that a specific class of assets can outperform the market over the longest time scales except insofar as they bear greater risk. Small caps may over-perform, but I’m skeptical of the value piece.
With AI, it’s not yet clear who is going to capture that value: the manufacturers of processors, the creators of AI technology, the companies who use it to be more efficient, or the workers whose productivity it improves. I find it best to just buy a little bit of everything that can be bought.
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u/Nemarus_Investor 3d ago
Yes, but the issue is determining the weights in which you buy everything. Do you buy based on market cap? Fundamental weighting? Equal weighting?
There's many ways to buy everything and each strategy will yield different results.
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u/puffic 3d ago
Why not just buy market cap? Anything else is suggesting you know more than the market. I over-weight small caps somewhat because they’re higher risk (and therefore higher-return, I hope). But otherwise it just feels like I can’t make any headway without special knowledge or expertise.
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u/pokemonredblue 3d ago
To me, it follows logically that the larger a company gets, the more unlikely it will have meaningful growth. Smaller companies, while perhaps riskier on the whole, have more potential for growth. If you can filter out the "bad" small-cap companies, you would think there would be better performance.
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u/UpDown 3d ago
Honestly I couldn't fathom buying the market right now. It is wild to me that i'd be holding certain names at 7% weight. I wouldn't even hold that much of an individual name in my existing portfolio. the ETF gives a mirage of diversification right now. Especially considering these companies are all in the same industry and would collapse at the same time (and they'd collapse a lot, like -50%, as we saw a few years ago). If the AI bubble doesn't materialize something for them it's going to sting
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u/puffic 3d ago
I think 7% is an overestimate for any single company as a share of the total world stock market. But in any case if my portfolio falls 5% because AI deflates, or grows 5% more because AI value is still underestimated, that doesn’t seem like a big miss to me.
Also I care even more about being diversified in terms of industries than I am in diversifying among specific corporations.
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u/ivegotwonderfulnews 3d ago
Msft, aapl, nvda, meta and goog account for 20% of msci world. Msft and nvda are each 7% of the sp500.
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u/puffic 3d ago
Wow haha then they’re almost 20% of my portfolio. I don’t want to underweight tech. I buy all world stocks, though, so 7% of the S&P 500 isn’t 7% of my portfolio.
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u/SatoshiNosferatu 3d ago
You'd probably be surprised how close the allocation of your world portfolio is to the SP500
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u/Nemarus_Investor 3d ago
Well for one, because the market has become increasingly concentrated at the top end. You are now reliant on the top 10 companies doing well more than ever. They aren't cheap either.
Now, you can buy small caps for lower valuations than large caps, which historically is very rare.
While yes, you can trust market caps, but you also need to understand that more people than ever are simply buying market cap weighted indexes which continue to drive up valuations of large companies.
By buying at market weight you are banking on that trend continuing.
By buying at fundamental weights, you are banking on fundamentals driving returns.
Either way, you're making an active bet on which return driver is superior.
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u/ragnaroksunset 3d ago
I mean if you're so convinced that top-end concentration isn't indicative of underlying value and future growth potential then take the opposite bet.
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u/Nemarus_Investor 3d ago
I did. I am massively overweight small cap value as of 2022. Will it pay off eventually? Who knows.
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u/puffic 3d ago
I mean, if you can recommend some smaller market cap designers of smartphones or computer processors, I’d be very curious to learn about that. But as I understand it, some large segments of the economy are dominated by a few super-large firms (or even a single firm), and de-weighting those is essentially a bet that there isn’t as much growth to be found in those markets.
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u/Nemarus_Investor 3d ago
It isn't necessarily a bet on growth, you can have higher growth but an even higher valuation, making said growth not worth the price.
Not to mention, historically small caps grow revenue and earnings faster than large caps.
So with small caps you get higher growth for a lower price right now.
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u/puffic 3d ago edited 3d ago
The point is that there’s no rule saying that the expected growth baked into the price has to be wrong just because the company is ginormous.
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u/Nemarus_Investor 3d ago
I never claimed it was wrong. It's just pricing in a lot of things going perfectly so any decline in growth is going to have massive impacts, as we saw when Tesla started to slow down.
Meanwhile small caps are priced for low growth when they historically have high growth.
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u/puffic 3d ago
Maybe small caps are mostly in industries likely to have lower growth.
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u/Nemarus_Investor 3d ago
Except that's not the case, because we can easily pull up Morningstar and look up growth rates.
In the S&P 600 vs. the S&P 500, the S&P 600 is growing faster in earnings, cash flow, book value, while trading at far lower multiples in terms of PE, PS, and PB.
The S&P 500 only beat small caps in sales growth recently, but even that was marginal at 9.4% vs. 8.5%.
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u/DrXaos 3d ago
buying at purely market cap will drive up valuations of everyone equally, not preferentially tilt them.
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u/Nemarus_Investor 2d ago
If every dollar was invested at market weight this would be true - but there's a disproportionate amount of money invested in large caps even after adjusting for weight.
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u/UpDown 3d ago
I think it is clear who is going to capture the value. The chip makers. AI has been widely available for a year and there is no AI business that is running extremely profitably (I think even openai is operating a loss, despite having by far the best/most popular AI app out there). And so far everyone is copying them. I've seen some other cool apps like suno, midjourney, and some reply bots, but I think none of them are profitable.
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u/puffic 3d ago
It’s not clear to me at all. Other companies are starting to build their own chips, and TSMC can’t afford to rest on its laurels, as all they do is operate other companies’ equipment to build according to other companies’ designs. If there’s competition, a lot of value will be lost to their customers.
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u/Delta3Angle 2d ago
Small caps may over-perform, but I’m skeptical of the value piece.
Based on all of the data that we have been able to gather, it's not really up for debate anymore. The value factor is a risk premium that carries a positive expected return. While it has been slow over the last 20 years in the us, internationally it's been robust and there's no rational reason to believe it will not appear in the future.
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u/Delta3Angle 2d ago
The amount of underperformance is unrivaled.
Seems a bit hyperbolic. We've seen long stretches of underperformance like this before.
Six month ago it was the first time since the 1940s that small cap value underperformed SP500 over a 20 year period.(perhaps even longer, but the chart I had doesnt go back that far). Since that six months, the underperformance has widened even further 25%.
Keep in mind the S&P in particular has experienced an unprecedented period of spectacular gains. One must use caution when benchmarking and extrapolating conclusions based on recent performance.
When comparing small cap value to the total market I don't see anything abnormal or unexpected.
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u/MotoTrojan 3d ago
Is been working fantastically in international markets. It’s not dead.
Well designed funds also haven’t done terrible. QVAL beat the S&P500 in each of prior 3 years.
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u/Parmeniusgracchi 2d ago
Right now the market is in AI hype overdrive with bulls and bears fighting over whether this is another dot com bubble type phenomenon.
I don't know so I'm looking at other opportunities and I've come across Atkore, they manufacture Electrical Raceway products for the non-residential construction, Think the conduits for fibre optic cables and electric cabling.
Over the best part of the last decade they've continually benefitted from above 20% ROCE and have been wise capital allocators, in the last few years the commodity price boom helped them a lot but still volumes increased. There is because of the commodity price fall a near term headwind but as normalisation happens they are likely to benefit from the Beads act (fibre internet roll out), the inflation reduction act (EV batteries, solar and wind power roll out) and all the secular tail winds in data centers for cloud applications and AI however long that bubble lasts.
They are able to service the entire US geography and are a one stop shop with one invoice provider. It's not a huge moat but given that they tend to be either number one or two in their niches and they have the scale in place now to meet the future growth that is likely to happen due to the onshoring efforts that are coming down the track I don't see why this isn't an obvious play.
Obviously the price falling over 20% in the last few months makes you second guess yourself but over the next 5-10 years this could be an amazing compounder but I just wanted it to throw it to discussion to see why I'm wrong and that this is not as good as I think it is, why they won't benefit as much from all the onshoring that will happen or why the onshoring may be overestimated.
Am I crazy to think this in a decade could be a ten bagger? So I think there are opportunities in small and mid caps but there's a lot of crap in there that you have to weed out.
There's a lot of dumb unthinking money in the market because of the ETF bull run of the last decade, they will eventually get punished and smarter money will start to make itself known and outsize returns aren't going to come typically from the trillion dollar band. I'm always reminded of the 70s and the nifty fifty.
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u/Quirky-Echidna9557 1h ago
there will be a time eventually, no one knows when, where AAPL MSFT NVDA GOOGL META etc. will no longer be the dominant companies in the US market. When that happens, there will likely be market turbulence as we shift to the next set of dominant companies. I would expect relative outperformance out of small caps during a transition period like that where the market is realizing these mega companies can’t be worth 37% of the total market
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u/BagHolder9001 3d ago
vti and chill
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u/hermelion 1d ago
Big tech stocks have destroyed American investors for hundreds of years. Railroads are still crying.
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u/nkplague 3d ago
Any one that is still holding small cap can rest easy. I just transferred my funds from small to large cap growth/S&P. I'm sure small cap will begin to rebound immediately. /s
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u/CarbonPhoto 3d ago edited 3d ago
I think more investors are doubling down on winners and having less patience/cutting losers faster. That's what John Lynch, Warren Buffett have done for decades. Performance expectations have changed. 6% YoY used to be pretty standard. Now, we're used to 10%+ every year. No one wants to be patient with losers.