New Wrinkles on Old Investing Truths: The Era of the Small Cap

Photograph by Scott Eells/Bloomberg

Readers of this byline appreciate its ardor for “Perception,” the data and joke-rich investing monthly put out by The Leuthold Group. The April book crunched surprising data that got me thinking about parallel drivers of long-term market performance: the significance of dividends to total return, and exposure to smaller-cap companies.

For starters, notes author Doug Ramsey, while the U.S. market has lately seen a muted celebration of nominal all-time highs, it’s important to note how pitifully the traditional, capitalization-weighted Standard & Poor’s 500 index has performed since setting its Irrationally Exuberant record almost exactly 13 years ago, i.e., back when mega-members Cisco Systems, Dell, and Microsoft could do no wrong. So much for that bias. According to Leuthold, an equal-weighted version of the S&P 500—one that gives every component the same representation—has since outpaced its traditional counterpart to the tune of 115 percent vs. 2.7 percent. Meaning the index’s small and midsize companies have been crushing their blue chip cousins.

Another data point in the revenge of smaller companies: in December 1999, near the peak of big-cap mania, small caps traded at a 40 percent valuation discount to their big cousins. Now, after a decade-plus of hedge funds and buyout shops flocking to small, highly acquirable companies, they fetch a 19 percent premium. Moral of the story: Never forget to go small and midsize when investing.

Leuthold accompanies that analysis with one that shows surprising stock vs. Treasury returns in the 100 years since the Federal Reserve was authorized. While it’s commonly believed that the S&P 500 would, over the long-haul, outperform 10-year T-bonds—more risk, more reward—Leuthold’s Ramsey calculated that both have actually posted the exact annual gain of 5.2 percent since 1913. That is, until you factor in the kick of S&P 500 dividends, which goosed the annualized total return to 9.7 percent. Moral of the story: “Dividends,” writes Ramsey, which have been “overlooked in the past couple of decades, until very recently, are obviously a critical piece of this record.”

Though dividends have long been viewed as the province of the biggest and bluest of corporations, small guys are increasingly paying out dividends, too. Jenny Van Leeuwen Harrington, of equity-income shop Gilman Hill Asset Management, says that small and midcap companies make up her largest number of new investment candidates. “There are,” she notes, “a number of companies that have recently dramatically increased their dividends or that have a long history of steady dividend payments but for various reasons have never been terribly liquid or grown into a large market capitalization.”

She points to Garmin, with its $6.8 billion market cap, as well as $1.8 billion large cap MineSafety Appliance. In addition, she says investors continue to flock into master limited partnerships in search of dividend income; most MLPs are in the small to mid-market cap range and have distribution yields well above the broader market average. “Not only are the small to midcap stocks providing some of the highest dividend yields,” says Van Leeuwen Harrington. “But they are also providing some of the strongest capital appreciation.”

Moral of the whole story: You could do worse than diversify out of certain long-held investing truths.