Catching Stardust

Finding Smaller Stocks That Can Shine

12 November 2020
4 min read


Smaller stocks offer diversification benefits and investment opportunities that can’t be found in their larger brethren. But because large-cap stocks have been so popular for the last 10 years, many investors have missed out on the compelling stories and advantages smaller companies can provide. Our research aims to shine some light on the universe of smaller stocks by examining their perceived risks, performance drivers and return potential—particularly amid a recovery from the COVID-19 pandemic and recession. The time is right for investors to consider smaller investments that have the potential to sparkle. 

Cumulative outperformance of US small-caps vs large-caps
in 2020 recovery (Mar 18-Sep 30)
Number of Russell 2000 stocks returning over 100%
Jan to Sep 2020
$1.4 trillion
The market cap difference between Apple + Microsoft and the entire Russell 2000

Smaller stocks seem to have gotten lost in the US market’s fascination with its giant stars. After all, when Apple and Microsoft combined are worth more than all 2,000 stocks in the small-cap index, it’s hard to see the miniature companies that look like specks of dust in the equity investing universe.

But every small company is a world in and of itself. And ignoring smaller stocks is a big mistake, in our view. Small- and SMID-cap stocks can offer investors distinct advantages, such as powerful growth drivers, innovative businesses, compelling company-level improvements and attractive valuations. What’s more, smaller companies aren’t nearly as risky as widely perceived. When carefully selected with a disciplined investing process, we believe a portfolio of smaller stocks can offer strong long-term return potential—especially in today’s environment. 

What’s Behind the Small-Cap Malaise?

Performance patterns of smaller stocks can at times be difficult to explain, particularly over shorter time frames. Over the long run, however, smaller-capitalization stocks have delivered an annualized return of about 11%, outperforming their larger cohorts by at least 120 basis points a year on average. While that doesn’t sound like much of a difference, consider this: $100 invested in each of the three indices in 1926 would now be worth $2.3 million from small-cap, $1.8 million from SMID-cap and $0.7 million from large-cap.

But since 2008, market currents have shifted. Investment trends have favored larger-cap stocks, at least temporarily, while investors sought safety from the below-trend economic recovery following the global financial crisis (GFC), and now the COVID-19-induced recession. During market crises, investors tend to shun smaller stocks because they’re widely perceived as riskier than their larger peers. But they also tend to rebound strongly during recoveries (Display).

US Smaller-Caps Have Led US Large-Caps Following Severe Crises In The Past
Russell 2000 vs. Russell 1000 Relative Cumulative Performance (Percent)
Three clusters of two bars each showing small cap underperformance during a crisis and small cap outperformance following the crisis.

Past performance does not guarantee future results.
Cumulative returns used for all time periods shown
An investor cannot invest directly in an index, and index results are not indicative of the performance of any specific investment, including an AllianceBernstein fund. Indices do not include sales charges or operating expenses associated with an investment in a mutual fund, which would reduce total returns.  
As of September 30, 2020.
Source: FTSE Russell and AB

Smaller-cap stock prices are more volatile than those of larger-caps, but this added volatility can create opportunity. Lower trading liquidity for small-caps can lead to inefficiencies and fundamental mispricing, especially in market crises. Trading liquidity is often a function of investor interest, and lesser-known investment stories are often overlooked in favor of larger, better-known entities such as mega-cap technology companies.

Those large-cap technology stocks have reshaped global equity markets this year, as their prices and market caps rocketed skyward. While these companies have captured investors’ attention and dollars, we believe that their rise makes the case for diversification across asset classes, such as smaller-caps, even stronger

Smaller Stocks Make Bigger Splashes

So why have large-caps been so popular over the last decade? Governmental policies, global quantitative easing, and even the rise of passive investing, have fueled large-cap gains. Today it’s as if the laws of physics have been suspended: the largest companies keep getting larger, like trees growing to the sky.  

But the laws of physics aren’t simply suggestions—they are laws. For example, the largest animals in the jungle aren’t always the mightiest. Elephants are big and strong, capable of carrying 130 humans or up to 1.5 times their body weight. But the mighty ant can carry up to 5,000 times its body weight. Which offers the better long-term return: the big lumbering elephant or the tiny but relatively stronger ant? The largest targets are also easiest to take down. As we’ve seen in previous market bubbles, some of the elephants are eventually taken out by smaller, more nimble new products and competitors that undercut older business models and products.

Some of the largest US companies have made a pretty big splash year to date. For example, Amazon, one of the five largest companies in the S&P 500, has returned an incredible 70% through September 30, 2020. And by that day, the combined market cap of just Apple and Microsoft was $1.4 trillion greater than that of the entire Russell 2000 small-cap index (Display).

The $1.4 Trillion Smoke Screen: Smaller-caps Are Where The Future Giants Are Hiding
A line graph that measures the return of the Russell 2000 Index market capitalization versus that of Apple plus Microsoft.

Current analysis does not guarantee future results. 
As of September 30, 2020
Source: Bloomberg, FTSE Russell and AB

Past performance, historical and current analyses, and expectations do not guarantee future results. There can be no assurance that any investment objectives will be achieved. The information contained here reflects the views of AllianceBernstein L.P. or its affiliates and sources it believes are reliable as of the date of this publication. AllianceBernstein L.P. makes no representations or warranties concerning the accuracy of any data. There is no guarantee that any projection, forecast or opinion in this material will be realized. Past performance does not guarantee future results. The views expressed here may change at any time after the date of this publication. This document is for informational purposes only and does not constitute investment advice. AllianceBernstein L.P. does not provide tax, legal or accounting advice. It does not take an investor’s personal investment objectives or financial situation into account; investors should discuss their individual circumstances with appropriate professionals before making any decisions. This information should not be construed as sales or marketing material or an offer or solicitation for the purchase or sale of any financial instrument, product or service sponsored by AB or its affiliates.

The views expressed herein do not constitute research, investment advice, or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

MSCI makes no express or implied warranties or representations, and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed or produced by MSCI.

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