‘Why Should I Own Small Caps?’
Small cap managers get this question a lot. I can’t think of a segment of financial services asked to justify its existence as often. Just once, I’d like to hear someone ask a large cap manager why they should own stocks. My guess is it rarely comes up.
Obviously, it’s a fair question. By definition, small caps are a niche asset class with low mindshare and a lot to prove. The small cap portion of the Russell 3000 accounts for just 8% of the index, and combined, its 1969 constituents are smaller than one Apple, Nvidia or Microsoft. Consequently, small caps are usually an afterthought, always a garnish, never the entrée.
Given the frequency of the question, you would think purveyors of small cap strategies would have a better answer, but it usually goes like this:
Small caps have historically outperformed.
Small caps are currently underperforming.
This could be their year!
Reminiscent of fans of cellar-dwelling teams, this argument seems motivated more by hope than fact. Going back to 1936, it’s true that small caps outperform large caps about two-thirds of the time. But it’s also true that small caps have underperformed 13 of the past 16 years. If relative performance is their primary allure, small caps haven’t held up their end of the bargain.
The next logical question is why I’ve chosen to specialize in an asset class with limited scale and low investor appetite (at least at present). It’s simple, small caps are less efficient. Because the universe is broad and can absorb finite capital, opportunities often go undiscovered. While investing doesn’t award points for originality, I’d rather uncover the next great company you’ve never heard of than be the thousandth spectator at the Nvidia parade.
Last month I highlighted how fewer than 10% of large cap managers beat their benchmark over fifteen years. Contrast this with small caps, where the median manager beats their benchmark 69% of the time. I enjoy a challenge as much as anyone, but if earning your fee is your primary goal (and in my case, it is), I know which odds I prefer.
In that same letter, I also highlighted how passive has reshaped investing as we know it. There are numerous small cap ETFs, but 40% of the Russell 2000 is currently unprofitable. To side-step this, you could buy an S&P 600 ETF which insists on profitability for inclusion. But both indices suffer from the same flaw, they punish their best performers by kicking them out. The Russell 2000’s last breakpoint was $4.6 billion, meaning anything larger than that was immediately sold. While index adherence is important to some, it makes little sense for a taxable investor to incur capital gains just to say they look like the benchmark.
Lastly, you can’t discuss the attractiveness of small caps without mentioning the dominance of megacap tech. While most of you are familiar with how concentrated the S&P 500 has become (the 10 largest companies now account for 36% of the index), it’s extremely rare for the largest companies to also be the fastest growing. Sort the S&P 500’s ten largest companies by decade and they’re typically mature businesses with predictable growth and steady capital returns (think GE, Exxon Mobil or J&J). Contrast that with Nvidia which is up 23-fold in five years. When the largest companies are also the best performing, diversification will be a cost, not a benefit.
That same exercise reveals that size is often a constraint on future returns and eventually, competition comes for us all. The 10 largest companies used to include unassailable businesses like Sears Roebuck, Xerox, Eastman Kodak and Polaroid. I’m not suggesting that Apple or Meta will become similarly obsolete, but periods of extreme concentration have a way of correcting themselves and seldom persist for long.
I’m not hazarding a guess as to whether small cap’s streak of underperformance is at its end (and a guess is all it would be). But one of the timeless tenets of investing is that diversification often proves valuable when you least expect it. Small cap managers have a much better track record of adding value than large and passive approaches would seem suboptimal. That’s why I invest in small caps.
Sincerely,
Dan Walker
General Manager
—-
DISCLOSURE
This material is confidential and may not be distributed or reproduced in whole or in part without the express written consent of Epigram Capital, LLC (the “Investment Manager”). This material is not intended to provide, and should not be relied on for, investment, tax, legal, or accounting advice. You should consult your own investment, tax, legal, and accounting advisers before engaging in any investment transaction. The information and opinions contained in this document are for background purposes only and do not purport to be full or complete. No representation, warranty, or undertaking, express or implied, is given as to the accuracy or completeness of the information or opinions contained in this document, and no liability is accepted as to the accuracy or completeness of any such information or opinions.
PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.
This material may contain certain forward-looking statements and projections regarding market trends, investment strategy, and the future asset allocation of the Fund, including indicative guidelines regarding position limits, exposures, position sizing, diversification, and other indications regarding the Fund’s strategy. These projections and guidelines are included for illustrative purposes only, are inherently predictive, speculative, and involve risk and uncertainty because they relate to events and depend on circumstances that will occur in the future. The guidelines included herein do not reflect strict rules or limitations on the Fund’s investment program and the Fund may deviate from the guidelines described herein. There are a number of factors that could cause actual events and developments to differ materially from those expressed or implied by these forward-looking statements, projections, and guidelines, and no assurances can be given that the forward-looking statements in this document will be realized or followed, as described. These forward-looking statements will not necessarily be updated in the future.