Your Investment Approach: Small Cap Companies and Value Stocks
There are a number of things that impact the success of your investment portfolio: time horizon, economic conditions, size and success of a company, types of investments… the list goes on.
And when you’re comparing this vs. that, it’s hard to always know the best approach to take.
That’s why we’ve been going through a series on building your own investment approach. The goal is to look at different factors and influences that impact an investment portfolio so you are empowered to make the right choices.
So far, we’ve covered topics like:
We wrapped up the series in episode 69 of The Canadian Money Roadmap podcast, where I dove into characteristics of companies that you may want to consider for building a long-term investing portfolio.
This relates to factor investing, a strategy in which you invest based on certain characteristics.
Here we’ll look at two of them: the size of a company (large vs. small cap) and relative price of stocks (growth vs. value).
Large vs. Small Cap Companies
The first characteristic to consider is the size of a company, referred to as a small, mid, or large-cap. It’s a short form of “market capitalization,” which multiplies the number of a company’s shares by its price per share.
Large-cap companies are the big names that garner a lot of media attention—Apple, Amazon, Meta, Tesla, and the like. They are often thought to be the best way to earn outsized returns because of how large and successful they are.
But is that always the case?
Performance History
Data shows us that, in fact, it’s the small-cap companies that earn higher returns. Data compiled by Dimensional illustrates this:
Canada (1988-2021): Small caps outperformed large caps by 8.89% to 8.56%, on average.
US (1928-2021): Small caps outperformed 12.14% to 10.19%, on average
Developed markets excluding Canada and the US (1970-2021): Small caps outperformed by 14.17% to 9.4%, on average.
Emerging markets (1989-2021): Small caps outperformed by 12.56% to 9.7%, on average.
This shows that across countries and time periods, small-cap companies have outperformed large-cap companies. This reflects the average, however, and includes periods of time when this wasn’t the case.
The data presents a strong case for including small-cap companies in your portfolio, but how many funds include them? Let’s look at three real-world examples:
Vanguard’s VFV: This fund is the S&P 500, where 0% is invested in small caps.
Vanguard’s VUN: This fund looks at the total US market, and 9% is invested in small caps.
Dimensional’s US Core Equity Fund: This fund has 16% exposure to small-cap stocks.
The first two are index funds that DIY investors or anyone can access. The third is not available to every investor and so you’d need to purchase it through an advisor who is approved to offer Dimensional funds.
The takeaway here is that “pure” index funds don’t typically get meaningful exposure to small-cap companies. So, if this is an approach you want to take, you need to find dedicated small-cap funds, typically by working with an advisor to do so.
Investing in small-cap stocks is a bit trickier, too, because they’re not followed as much in the news—it’s harder to know what’s going on there.
That said, the evidence is quite compelling to orient your portfolio more toward small-cap companies if you are really looking to maximize your returns in the long term.
Growth vs. Value Stocks
The second fact to look at besides the size of the company is the relative price. This is referred to as “growth” or “value” stocks:
Growth stocks are companies that are rapidly growing, expanding, and innovating. Because of this, they’re priced according to future value. The idea is that you pay a premium today for a bigger payoff tomorrow.
Value stocks are, in contrast, “good deals.” They’re valued based on the company today and are typically boring, stable, profitable organizations.
The line between growth and value stocks is not always very clear, though.
For example, Meta (formerly Facebook) moved from growth to value back to growth again within a year.
Meta’s stock was trading around $350.00, putting it in the growth category. This was largely based on their work around the metaverse, where tons of money was being thrown at this innovative, future-thinking project.
But then a few things happened—key staff like Sheryl Sandberg resigned, Apple changed policies that impacted their ad revenue, and shareholders started getting wary of how much money was being thrown into the metaverse.
This led to a stock price drop to under $100.00 per share. It became a value stock.
However, things are constantly changing in business. Mark Zuckerberg addressed shareholders and talked about 2023 being the year of fiscal responsibility for Meta. Shareholders and investors liked that, and the stock price jumped 25%.
The point here is that stock prices fluctuate all the time based on what’s happening in the company and the world. So, that line between value and growth is not always crystal clear.
Performance History
Like large-cap companies, growth stocks often get all the press attention. But, similarly, they’re not necessarily always the best choice.
Data shows that boring, financially prudent companies that turn profits—value stocks—win out over the long run. Let’s look at some global data again:
Canada (1977-2021): Value outperformed growth by 10.85% to 8.29%, on average.
US (1928-2021): Value stocks outperformed growth stocks by 12.6% to 9.76%, on average.
Developed markets (1975-2021): Value outperformed growth by 13.05% to 8.96%, on average.
Emerging markets (1990-2021): Value outperformed growth by 11.28% to 6.61%, on average.
This paints a pretty strong case for value stocks over growth stocks, as they stand up across time periods and geographic locations.
However, higher returns are correlated to higher risk and there’s always a risk of underperformance over short or extended periods of time. For example, the last decade or so—until quite recently—has seen growth stocks outperform value stocks, which is contrary to the historical pattern.
Things ebb and flow over time, so it’s important to choose a direction and stick with it over a long time period. I think the data is compelling to choose value stocks as part of your investment strategy, so long as you can hold on to them for extended periods of time.
So, if you are interested in leaning into some academically-backed factors for success, you may want to look into more exposure to both small-cap companies and value stocks in your portfolio.
DIY investors or those working with an advisor may find this route worthwhile. Others will prefer a simpler, index fund approach, and that’s okay too.
The goal here is to highlight some factors that may be meaningful to your investment portfolio so you can make the best decisions for your approach. There’s no right or wrong, but the more knowledge you have, the better positioned you are to ask the right questions to understand how to make the best decisions.
You can dive deeper into this topic on small-cap companies and value stocks by listening to episode 69 of The Canadian Money Roadmap podcast, or episodes 63-66 for the rest of the series on building your investment approach.
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Evan Neufeld is a CERTIFIED FINANCIAL PLANNER® professional in Saskatoon, Saskatchewan and offers both investing and fee-only financial planning services.
*Disclaimer: Any numbers or rates of returns are used for illustration purposes only and should not be taken as fact. Note that the information in this article is current to the time of writing but is not guaranteed as up-to-date past then.
This article and accompanying podcast do not constitute personal financial advice. Evan Neufeld is a CERTIFIED FINANCIAL PLANNER professional in Saskatoon, Saskatchewan, and provides this Canadian personal finance content for educational purposes to the public.