All stocks are risky, particularly when compared with traditional cash or bonds. Rather than asking, “Should I invest in large-cap rather than small-cap stocks (or vice versa),” an investor should instead ponder how exposure to either would best reflect her risk tolerance. That answer typically lies not in security selection, but in asset allocation.

Large-cap stocks are historically less risky than small-cap. In theory, large-cap stocks have steadier cash flows than their small-cap cousins, helping them better weather market turbulence. Prior to 2020, a publicly traded, unprofitable large-cap company was possible but rare. 2020’s Covid-related lockdown, however, eradicated cash flows for many of the world’s largest consumer services companies, dismantling years of profitable earnings from the likes of Marriott, Disney, and Delta Airlines. Even Amazon, whose e-Commerce and Amazon Web Services (AWS) platforms reaped the benefits of the global lockdown, reported its first loss in nearly two decades for the fiscal year 2022.

By contrast, small-cap companies, particularly those in healthcare and technology, may remain unprofitable for years. Less than one-third of the small-cap companies composing the Russell 2000 index are profitable. In times of severe market stress—and absent government bailouts—small cap companies are more likely to falter. 136 public US companies failed during the 2008 Financial Crisis; an annual number bested only by the March 2000 Dot.com Crash that erased 263 public companies in 2001.

That is not to say large-cap companies are immune from failure. Spectacular large-cap collapses, in which all or more than 90% of shareholder value evaporated, litter history: Enron, Lehman Brothers, and Valeant Pharmaceuticals, not to mention the Silicon Valley and First Republic bank failures earlier this year. By and large, however, large-cap companies and the indexes they constitute are less volatile. That muted volatility is critical to capital preservation during times of market stress. Large-cap stock indexes have the propensity to better exhibit consistent, steady-eddy growth over long horizons, while small-cap indexes can vacillate wildly over short intervals.

Yours truly invested in the SPDR S&P 600 Small Cap ETF in January 2020 only to watch it lose more than 40% within six weeks. By May of 2021, that same ETF had rallied more than 130% from its March 2020 low. By contrast, the SPDR S&P 500 Large Cap ETF dropped ~30% then rallied ~85% during the same period. It is worth noting that the S&P 600 index has a quality bias that excludes unprofitable small-cap companies. Despite that bias, small-cap stocks still displayed more erratic behavior than large-cap.

In addition to stabler cash flows, large-cap companies typically garner more abundant Wall Street research, offer more in-depth financial (and ESG-related) transparency, and support larger investor relations teams that can better field investor questions and publish commentary. Resource-constrained, small-cap companies may employ just one-person or entirely outsource IR teams with limited scope to track ESG-related criteria or support financial publications beyond basic regulatory disclosure. They entice fewer analysts to initiate coverage, and when they do, those analysts rarely represent the opinions of large investment banks.

Small-cap investment managers may argue such limited disclosure offers an investor potentially unencumbered alpha generation. Sometimes they are right. Amazon IPO’ed in 1997 with a miniscule market cap of $300 million; today its market cap is $1.4 trillion. Microsoft came public in 1986 at just under $800 million. Its market cap today is $2.4 trillion. And Apple debuted publicly in December 1980 at $1.8 billion (at the time, the largest IPO since Ford), only to balloon to its current $2.8 trillion, impressive not just for its size but also because Apple flirted with bankruptcy in 1997. For those few small- to mega-cap wonders, far more small-cap companies have come and gone. Just ask a Gen Z colleague if she remembers TheGlobe.com, Webvan or iVillage.

Small-cap stocks are riskier, but that does not mean they should be altogether avoided. Because they may be nimble, small companies are often first to innovate, creating tomorrow’s solutions to today’s most pressing problems. Those that succeed may find themselves acquired at premium valuations by large-cap companies, generating a substantial return for shareholders.

Large- and small-cap equity vehicles can coexist peacefully and complement each other. For moderate to aggressive allocation profiles a modest allocation to small-cap equities may make sense, especially during early economic expansions. Investors with particularly long horizons, including endowments and foundations, and/or those with assets well in excess of immediate spending needs could arguably maintain perpetual exposure to capture the alpha boost small cap investing may provide.

To preserve capital during market dislocations but support long-term, compounded growth, Boston Common’s proprietary equity strategies, encompassing US, developed international, emerging markets and global impact, lean toward large-cap equities for their quality characteristics, volatility reduction, and transparency. The firm still periodically finds opportunities to invest in small-cap companies that are innovating to address climate transition, health & wellness, and financial inclusion. But its large-cap bias reinforces Boston Common’s efforts to embrace or improve upon already strong ESG-integrated business models and foster fruitful collaboration through strategic shareholder engagement.

 

Published On: September 6, 2023Categories: Thought Leadership