How to Understand The Small-Stock Rally

Small stocks so far this year have beaten their large-capitalisation brethren by a wider margin than they have in more than two decades, raising questions about what is driving the outperformance and what it means for the overall market ahead.

The year-to-date return for small-caps through the end of February was a remarkable 25 percentage points greater than that of large-caps (as measured by the 20% of stocks with the smallest market caps vs. the comparative quintile of the largest). While it isn’t unexpected for small-cap portfolios to beat large-caps over time—a long-term tendency that Wall Street analysts refer to as the “size effect”—what is unusual is the magnitude of the outperformance. It has averaged just 0.9 percentage point over all two-month periods since 1926, according to data from Dartmouth professor Ken French.

You have to go back to January and February of 2000, at the top of the internet-stock bubble on Wall Street, to find a two-month stretch in which the small-caps beat the large-caps by more. Their margin of outperformance over those two months was 41 percentage points.

Any parallel to the top of the internet-stock bubble is ominous, to be sure. But there are several idiosyncrasies to small-caps’ recent performance that stand in the way of drawing any straightforward analogies to the frenzy in small stocks that heralded the 2000 tech-stock crash.

Indeed, according to several researchers, small-caps’ recent strength may actually be something else in disguise—that is, it may have to do with factors other than just size, such as the battle between growth and value stocks.

That doesn’t mean there is nothing to worry about in this bull market, where valuations are stretched thin for many stocks. But it does mean that investors who are focused solely on the small-cap/large-cap divergence could be missing the bigger picture.

Here’s why.

1. Value versus growth

One distinction that is crucial for understanding the relative strength of small-caps this year has to do with where small- and large-cap stocks lie on the growth-versus-value spectrum. Small-cap stocks currently are far closer to the value end of the spectrum than large-caps, meaning they are trading for lower prices relative to their net worth.

A stock’s place on this spectrum is defined by its ratio of price to per-share book value, with the highest ratios at the growth extreme and the lowest at the value extreme. Consider the Russell Microcap Index, which contains the smallest 1,000 stocks in the broad-market Russell 3000 index. Its average price-to-book ratio was 2.5 as of the end of February, according to Russell Indexes. That compares with a 4.2 ratio for the Russell 1000 Index (which contains the largest 1,000 stocks) and a 5.7 ratio for the Russell Top 50 Mega-Cap Index (which contains the largest 50 stocks).

These are significant differences, according to Kent Daniel, a finance professor at Columbia University and a former co-chief investment officer at Goldman Sachs. He says that, on average, small-cap growth stocks tend to underperform the market, while small-cap value stocks tend to outperform. Since 1926, he says, the smallest-cap stocks closest to the growth end of the spectrum have lost 3.3% annualized, while the smallest most value-oriented stocks have gained 13.3% annualized.

This pattern has been especially strong in recent months, making it difficult to determine what accounts for small-caps’ relative strength this year. But Prof. Daniel says there is the distinct possibility that it is really a “value effect masquerading as a size effect.” If so, a bet on small-cap relative strength continuing is really a bet that value will outperform growth.

That bet may pay off in coming months, he says, and value could continue to outperform growth for many years. But he also says that value stocks have lagged behind growth stocks for at least a decade now, and while there have been numerous predictions of a value resurgence over that time, it hasn’t happened—at least not yet.

2. Sector bets

The benchmark indexes for small-caps and large-caps have different sector weightings, which also makes it difficult to gauge whether the recent relative strength of small-caps is actually due to company size.

Consider the information-technology sector. The ETF benchmarked to the largest 50 stocks currently has a 38.6% weighting to this sector, more than three times the 12.7% weighting of the Russell Microcap Index.

Conversely, the microcap index has more than 10 times the weighting of the largest-50-stock ETF to the industrials sector (11.7% versus 0.8%) and more than double the allocation to the financials sector (17.6% to 7.1%).

These differences are a big part of small-caps’ year-to-date performance, since industrials and financials have each outperformed the information-technology sector. It was just the opposite for calendar 2020, and sure enough, the smallest stocks lagged behind the largest last year.

Until there are small-cap and large-cap benchmarks with the same sector weightings—Prof. Daniel says he is unaware of any currently—it will be difficult to determine what is driving small stocks’ relative strength. If it is being caused by differences in sector weightings, however, it is likely to persist only if the sectors in which the small-caps are overweight continue outperforming.

3. Is the small-cap effect real?

This discussion also points to a more fundamental question that many researchers have been asking in recent years: Does the small-cap effect even exist, in and of itself? That is, do smaller firms really have higher returns than larger firms, on average, over long periods?

Andrea Frazzini, a principal at AQR Capital Management and an adjunct professor of finance at New York University, has concluded that it exists only among a very narrow group of stocks. He says that some of the relative strength of small-caps in recent months traces to speculative fervour for stocks outside that narrow group, making it risky to bet that it will continue.

According to his research, small-caps are a good bet to outperform the large-caps only if you limit your focus to companies with high financial quality. By financial quality he means firms that are profitable, have robust profit growth and a stable earnings stream and a high dividend-payout policy, among other characteristics. Many of the small companies that have performed the best so far this year don’t qualify.

Companies that have been bid higher in recent weeks through social-media investor campaigns—such as GameStop and AMC Entertainment—are two obvious examples, but they are hardly alone in not qualifying for Prof. Frazzini’s high-quality category. Nearly half of the 2,000 companies in the Russell 2000 small-stock index, for example, lost money in 2020.

Prof. Frazzini’s research therefore suggests that, if you want to bet on a continuation of recent small-cap relative strength, you should focus on small stocks that score high on various measures of financial strength, safety and quality. And don’t sweat the comparisons to that internet-stock frenzy of 20 years ago.

U.S. investors’ enthusiasm over Japanese stocks at this time last year turned out to be misplaced, but the market is again on the list of potential ways to diversify. Corporate shake-ups, hints of inflation after years of declining prices, and a trade battle could work in its favor.

Japanese stocks started 2024 off strong, but an unexpected interest-rate increase in August by the Bank of Japan triggered a sharp decline that the market has spent the rest of the year clawing back. Weakness in the yen has cut into returns in dollar terms. The iShares MSCI Japan ETF , which isn’t hedged, barely returned 7% last year, compared with 30% for the WisdomTree Japan Hedged Equity Fund .

The market is relatively cheap, trading at 15 times forward earnings, about where it was a decade ago, and events on the horizon could give it a boost. Masakazu Takeda, who runs the Hennessy Japan fund, expects earnings growth of mid-single digits—2% after inflation and an additional 2% to 3% as companies return more to shareholders through dividends and buybacks.

“We can easily get 10% plus returns if there’s no exogenous risks,” Takeda told Barron’s in December.

The first couple months of the year could be volatile as investors assess potential spoilers, such as whether the new Trump administration limits its tariff battle to China or goes wider, which would hurt Japan’s export-dependent market. The size of the wage increases labor unions secure in spring negotiations is another risk.

But beyond the headlines, fund managers and strategists see potential positive factors. First, 2024 will likely turn out to have been a record year for corporate earnings because some companies have benefited from rising prices and increasing demand, as well as better capital allocation.

In a note to clients, BofA strategist Masashi Akutsu said the market may again focus on a shift in corporate behavior that has begun to take place in recent years. For years, corporate culture has been resistant to change but recent developments—a battle over Seven & i Holdings that pits the founding family and investors against a bid from Canada’s Alimentation Couche-Tard , and Honda and Nissan ’s merger are examples—have been a wake-up call for Japanese companies to pursue overhauls. He expects a pickup in share buybacks as companies begin to think about shareholder returns more.

A record number of companies have also delisted, often through management buyouts, in another indication that corporate behavior is changing in favor of shareholders.

“Japan is attracting a lot of activist interest in a lot of different guises, says Donald Farquharson, head of the Japanese equities team for Baillie Gifford. “While shareholder proposals are usually unsuccessful, they do start in motion a process behind the scenes about the capital structure.”

For years, money-losing businesses were left alone in large corporations, but the recent spate of activism and focus on shareholder returns has pushed companies to jettison such divisions or take measures to improve them.

That isn‘t to say it is going to be an easy year. A more protectionist world could be problematic for sentiment.

But Japan’s approach could become a model for others in this new world. “Japan has spent the last 30 to 40 years investing in business overseas, with the automotive industry, for example, manufacturing a lot of the cars in the geographies it sells in,” Farquharson said. “That’s true of a lot of what Japan is selling overseas.”

Trade volatility that hits Japanese stocks broadly could offer opportunities. Concerns about tariffs could drag down companies such as Tokio Marine Holdings, which gets half its earnings by selling insurance in the U.S., but wouldn’t be affected by duties. Similarly, Shin-Etsu Chemicals , a silicon wafer behemoth that sells critical materials, including to the chip industry, is another potential winner, Takeda says.

If other companies follow the lead of Japanese exporters and set up shop in the markets they sell in, Japanese automation makers like Nidec and Keyence might benefit as a way to control costs in countries where wages are higher, Farquharson says.

And as Japanese workers get real wage growth and settle into living in an economy no longer in a deflationary rut, companies focused on domestic consumers such as Rakuten Group should benefit. The internet company offers retail and travel, both of which should benefit, but also is home to an online banking and investment platform.

Rakuten’s enterprise value—its market capitalization plus debt—is still less than its annual sales, in part because the company had been investing heavily in its mobile network. But that division is about to hit break even, Farquharson says.

A stock that stands to benefit from consumer spending and the waves or tourists the weak yen is attracting is Orix , a conglomerate whose businesses include an international airport serving Osaka. The company’s aircraft-leasing business also benefits from the production snags and supply-chain disruptions at Airbus and Boeing , Takeda says.

An added benefit: Its financial businesses stand to get a boost as the Bank of Japan slowly normalizes interest rates. The stock trades at about nine times earnings and about par for book value, while paying a 4% dividend yield.

Corrections & Amplifications: The past year is expected to turn out to have been a record one for corporate earnings in Japan. An earlier version of this article incorrectly gave the time frame as the 12 months through March. Separately, Masashi Akutsu is a strategist at BofA. An earlier version incorrectly identified his employer as UBS.

How to Understand The Small-Stock Rally

Small-caps are drubbing large ones this year. What does it mean for what’s ahead?

1. Value versus growth

2. Sector bets

3. Is the small-cap effect real?