Investors often debate whether it’s more profitable to focus on large-cap stocks or small-cap stocks. Large-cap stocks are generally associated with stability and lower risk, while small-cap stocks are seen as more volatile but with higher growth potential. In this article, we will take a closer look at the long-term performance of small-cap stocks compared to large-cap stocks and explore some valuable insights into their cyclical nature.
To analyse the performance of small-cap and large-cap stocks, we will refer to the Sensex (a benchmark index of the Bombay Stock Exchange) and the Small Cap BSE index. While the Sensex represents the performance of large-cap stocks, the Small Cap BSE index focuses on small-cap stocks.
A Surprising Revelation: Similar Returns Over 20 Years
When examining the charts of these two indices over a period of nearly 20 years, one startling observation emerges – both indices have delivered similar returns. Despite the perception that small-cap stocks generate higher returns due to their growth potential, the data reveals that the returns of small-cap stocks have been on par with those of large-cap stocks.
This finding challenges the common assumption that small-cap stocks consistently outperform their larger counterparts. Investors often view small-cap stocks as riskier but potentially more rewarding investments, assuming they will generate superior returns in the long term. However, the historical data suggests otherwise.
Analysing the Divergences
To gain a deeper understanding, let’s explore the periods when the performance of small-cap stocks diverged from that of large-cap stocks. By examining these divergent periods, we can uncover patterns and potential opportunities for investors.
Period 1: 2007-2008
Towards the end of a major bull rally in 2008, small-cap stocks began to outperform large-cap stocks significantly. From May 2007 to January 2008, small-cap stocks surged by nearly 100%, while large-cap stocks increased by only 50%. However, this period of outperformance was short-lived, as small-cap stocks eventually fell back in line with large-cap stocks.
Period 2: GFC Fall in 2008
After the major market downturn in 2008, small-cap stocks experienced a more significant decline compared to large-cap stocks. While large-cap stocks fell by 40%, small-cap stocks plummeted by 60%.
Period 3: Recovery post GFC Crisis in 2009
Following the market recovery in 2009, small-cap stocks again took the lead and surged by 100%. In contrast, large-cap stocks only rose by 54%. However, this pattern showcased the cyclical nature of small-cap stocks, as they subsequently fell by 50% while large-cap stocks declined by a more modest 25%.
Repetition of the Cycle
This pattern of small-cap stocks outperforming large-cap stocks, followed by a subsequent decline, continued throughout the years. Similar divergence occurred in 2013, followed by a catch-up period, and later in 2016, indicating a repetitive cycle of performance swings.
We also saw a big divergence in 2018 when Smallcaps dropped 52% compared to 22% on the large caps
The COVID-19 pandemic once again highlighted the cyclical nature of small-cap and large-cap stocks. Since the pre COVID highs, small-cap stocks have gained 177%, while large-cap stocks have risen by 61%. These recent returns indicate that whenever there is a significant market event, small-cap stocks tend to outperform in terms of percentage gains.
Implementing a Strategy for Outperformance
While the long-term performance of small-cap and large-cap stocks tends to be similar, there is an opportunity for investors to potentially outperform the market by implementing a well-thought-out strategy that capitalises on the cyclical nature of small-cap stocks.
Mi 25 is a niche smallcaps focused strategy that aims to capitalize on the alpha one can see with the Smallcaps while offering downside protection during weakness by allocating to cash.
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