What Is Driving Small-Cap Stock Underperformance?

On this episode of The Long View, Keith Lee, lead portfolio manager on the Brown Capital Management Small Company Strategy, talks small-company investing, diversity in the investment industry, portfolio strategy, and more.

Here are a few excerpts from Lee’s conversation with Morningstar’s Christine Benz and Dan Lefkovitz.

Why Revenue Is a Better Indicator of Size Than Market Capitalization

Dan Lefkovitz: You’ve been a small-company investor for decades and you differentiate between small company and small cap. You look at operating revenue instead of market capitalization. Why do you make that distinction?

Keith Lee: We think revenues are a better indicator of size than market capitalization. And I’m going to go way back—when I came to Brown Capital in 1991, soon thereafter, IBM was in a downward price spiral. And we said that if the stock price of IBM drops far enough, IBM could appear in small-cap portfolios. And at that time, it was multibillion dollars in revenue, multibillion dollars in assets, hundreds of thousands of employees—anything but small. Fast forward to the dot-com era, dot-com was just the opposite. Many of these companies had market caps that were well in excess of a billion dollars and no revenues. And then in the great recession, a firm like GM, GM had $46 billion of revenues, but yet their market cap was a billion dollars. So, we just think that identifying and investing in companies early in their life cycles, particularly companies that can sustain growth over long periods of time. These companies tend to be innovative. At times to cutting edge of new technologies, of new areas. It’s exciting. But it’s also, when we get it right, it can be very rewarding for our clients and our shareholders.

What Is Driving Small-Cap Stock Underperformance?

Christine Benz: We wanted to ask about the state of the state for small caps. They’ve badly underperformed large caps in the US. And it seems like a lot of investor portfolios these days are pretty heavy on the large-cap stocks. How do you account for the small-cap underperformance?

Lee: I think if you look, like the last five years, large cap has certainly outperformed—the Russell 2000 Growth has returned a little over 5%, whereas the Russell 1000 Growth has been up about 17%. I think a lot of that has come from the larger tech companies—the “Magnificent Seven” has really added to that difference as well as the background drop. You looked at rising inflation. That certainly has not boded well for growth companies and certainly not small-growth companies. And I was reading a Wall Street Journal article within the last couple of months that said that small-cap stocks are historically cheap. And the S&P—don’t hold me to these numbers, but I think they’re pretty close—the S&P SmallCap 600 was on a forward P/E basis 13 times versus about 19 times for the S&P 500. And the Magnificent Seven—the Apples, Microsoft, Amazon, Metas of the world—they were at 32 times. Whereas the Russell 2000 was at about 15 times. And so, we know that small caps have struggled, as I mentioned, in high inflation or interest-rate environments, more than large companies. But I think that will change. Small cap generally outperform markets, large companies when there is an anticipation of Fed rate cuts. I think Morningstar has said that the Russell 2000 has risen about 25% during periods of increasing growth and slowing inflation since the ‘70s versus about 17% for the S&P. So long-winded way of answering your question, but those are some of the reasons why.