Readers who have adopted “tilts” toward small cap and value equities in their portfolios are probably aware that these stocks have outperformed large growth stocks in recent months. We cannot predict whether this trend will continue, but long-term investors can be confident in the rationale for these tilts.

Not all stocks have the same expected return. Information embedded in market prices allows us to identify stocks with higher expected returns. The current value of a company is the market’s best estimate of future cash flows discounted to the present by the rate of return the market expects. It stands to reason that stocks with low prices (value stocks) and lower market capitalizations (small cap stocks) should have higher expected returns.

This story is backed by solid data. Consider that a hypothetical $100 invested in a U.S. small cap value index in July 1926 would have grown to $360,816 today. But that same $100 invested in a U.S. large cap growth index would be worth only $8,927 over the same span.

Individual investors, however, do not have a time horizon of 94+ years, and these nine decades include prolonged periods when small cap and value equities have underperformed, sometimes by a wide margin. Recent years have been especially hard. December 31, 2020 marked the largest ten-year deficit in history, when small cap value stocks provided a total return of 128 percent, compared with 387 percent for large cap growth stocks. Last year was especially harsh; during 2020 small cap value stocks delivered only a 3.4 percent return versus an astounding 36.2 percent return for large growth stocks.

This differential is unlikely to persist in 2021. Indeed, a resurgence for small cap value stocks began just about one year ago, following the market bottom on March 23, 2020. Over the following 11 full months U.S. small cap value stocks have returned 111 percent, well outpacing both large cap growth shares (+58 percent) as well as the overall U.S. market (+57 percent).

Investors should form their portfolios with this history in mind. The decision to deviate from a simple all-market portfolio toward small and value stocks, and by how much, is a matter of preference and tolerance for risk.

Also In This Issue

Treasury Inflation Protected Securities (TIPs)
Saving for College
529 Savings Plans: Impact on Federal Aid
The High Yield Dow Strategy
The Dow Jones Industrials Ranked by Yield
Asset Class Investment Vehicles