Investing

DR Podcast 339: Small Cap Value vs. Growth: Which is Better?

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In this episode, Rob responds to a question from a listener, “Can you explain why small-cap value might not be the best bet?” Rob Berger breaks down small-cap vs. large-cap stocks as well as value vs. growth. Which is better for your portfolio? Does it matter?

"I wouldn't lose any sleep over it," Rob advises.

Be sure to look at value and growth when investing. Rob believes it shouldn't make or break your decision when choosing small-cap stocks. They are just two of many factors worth considering when creating your portfolio.

At Dough Roller, our goal is to help you invest smartly. That involves understanding the importance of value, growth, and capitalization size. Here's everything you need to know about small-cap value vs. growth so that you can make educated investment decisions.

Want to learn more about value stocks? Check out Betterment. This robo-advisor offers three types of value stocks to include in your portfolio. Read our Betterment Review here.

What Is Small Capitalization?

Small capitalization refers to a company’s size as measured by the value of its outstanding stock. Small-cap stock companies typically have valuations between $300 million to $2 billion. Some examples include Unisys Corp, Co-Diagnostics Inc., and Axos Financial.

These companies tend to grow profits and revenues faster than the average company. Some of the most valuable and powerful businesses were once small-cap stocks. Just imagine the financial payout if you had put money into Tesla, Apple, or Amazon when they were small.

What Is Large Capitalization?

Large capitalization may not be as sexy as its small-cap counterpart, but it is still a significant part of a well-rounded portfolio. Large-cap stock means the business has a capitalization of over $10 billion. These companies often have stocks in the top 70% of capitalization for the equity market.

Some examples of large-cap stocks include Microsoft, Facebook, and JPMorgan Chase & Co. These well-established companies make up some of the most influential and powerful organizations in the world. Their extensive financial track records and stability make them less volatile than startups.

Value vs. Growth

Value Stocks

Investing in value stocks is about finding diamonds in the rough. These companies have stock prices that don’t align with their actual value. Investors hope to invest in these undervalued companies and that the market will favor them with time. When the correction happens, the stock prices and their profits will rise.

Value companies don't fixate on rapid growth or profits. Some examples include Alaska Air Group Inc., Clear Channel Outdoor Holdings Inc., and Pacific Ethanol Inc. These companies may have fewer upsides than growth stocks, but they also have fewer downsides.

Growth Stocks

Growth stocks are among the most enticing investments. These companies want to grow quickly, generating either massive cash flows or revenues, in addition to profits. Growth organizations seek to expand, so they reinvest their earnings in new staff, technology, and acquisitions.

Growth stocks won't pay dividends. They have a "go big or go home" mentality. While they have higher upsides than value stocks, they typically come with more risk. Growth companies can have well-defined business plans and a pathway to profitability, but the investments don't always lead to a payoff.

Some of the companies that fall under the growth stock label include Unisys Corp., VirnetX Holding Corp., and XBiotech Inc. Unisys had a 10.3% year-over-year loss in the third quarter while cutting almost half of its operating income. XBiotech recently announced that it is creating a unique way to treat COVID-19 infections, while VirnetX holds coveted patents in software and technology.

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Portfolio Analysis: Small-Cap vs. Large-Cap

Let's use a real-world example to compare the importance of capitalization. Say you invested $10,000 in U.S. large-cap stocks and $10,000 in U.S. small-cap stocks starting in 1972. You've contributed another $1,000 every year until 2020.

So, which one had a better return? The U.S. small-cap stocks would have netted $5.5 million, while the U.S. large-cap stocks would have returned $4.1 million. What's remarkable is that the compound annual growth rate (CAGR) would have been nearly identical (13.8% to 13.14%), yet small-cap would have ended up earning you $1.3 million more dollars.

One of the reasons small-cap stocks performed better was their higher volatility. The stock's best year featured a 55.13% return on investment, while large-cap options peaked at 37.45%. In this scenario, greater risk meant greater rewards.

Do these results mean that small-cap stocks are a superior investment? Not necessarily. For starters, most investors aren't going to put all their money in large-cap or small-cap. There are also other investing factors to consider, such as personal debt and stock versus bond allocation, which we will discuss momentarily.

Alternative Analysis

Instead of grouping small-cap stocks by value vs. growth, we could categorize them based on their incorporation date. If you run the same experiment, some days of the week would outperform others. For instance, Monday might have the highest return on investment, with Friday having the lowest.

We wouldn't assume companies that incorporate on Mondays are inherently more likely to succeed. The incorporation date isn't a practical way to measure asset classes. It's significantly more valuable to look at underlying factors, like a company's debt-to-equity ratio, dividends, and price-to-earnings ratio. The same logic applies to categorizing companies as growth and value stocks.

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Does Value Outperform Growth?

One of the issues with the first example is that it is retrospective. We went back in time to create the scenario, already knowing how the future would unfold. We knew there were economic booms in the late 1970s and 1990s and recessions in 2008 and 2020.

The first example showed that growth beat value. That's not always the case, however. All we have to do is change the starting point to achieve different results.

Imagine repeating the $10,000 investment with $1,000 annual deposits but starting in 2000. The U.S. is exiting the dot-com crash, and while economic prosperity is ahead, the country also has to go through two recessions. The corresponding results see a flip-flop between large-cap and small-cap.

The large-cap portfolio generates $125,764 compared to the small-cap portfolios $105,353. While large-cap stocks had marginally less volatility, they had higher returns. They also had a 12.98% CAGR compared to 12.02% for small-cap.

Takeaways: Small-Cap Value vs. Growth

So, what do these results mean for your portfolio? We know that some small-cap exposure is a good thing. The U.S. has the most robust economy globally, and over the long term, produces sizeable returns on investment.

There are no guarantees that small-cap growth will outperform value over any period. Value stocks tend to do better in a bear market, but the results switch during bull markets. As a result, it's impossible to predict whether value or growth will have higher returns during a specific time.

Part of the problem is market timing. No one can guarantee whether the market will trend up or down in the coming months. Even the best financial advisors can only take educated guesses about the market's trajectory.

For the sake of argument, let's say growth stocks perform better than value stocks in bull markets. You might start investing in small-cap growth stocks at the beginning of 2020. The first three months would have been highly profitable as the Dow Jones and S&P 500 boomed.

However, the coronavirus pandemic would have flipped your fortunes. The recession would mean your small-cap growth stocks are now underperforming compared to small-cap value ones. Putting all your eggs in one basket would have left you at a high risk of unexpected economic fluctuations.

If you want to hedge your bets, you might have a mixture of the two. You may limit your risk exposure and top-end volatility. While mixed portfolios might not produce the maximum returns, they're an optimal way to steadily and consistently grow your investments.

If you have one takeaway from this article, it should be this: pick an asset class you’ll stick with over the long term. That perseverance is more important than selecting value, growth, or a blend. Don’t try to chase profits because one asset class is outperforming the other. Make a decision, invest your money, and watch it grow.

Other Factors to Consider When Investing

Amount Invested

Most financial advisors subscribe to the 50-20-30 rule, including Berger. Fifty percent of your income goes to essential purchases, like rent and food, and 30% goes to your less-essential needs, like entertainment and travel. The remaining 20% should beeline to your savings account.

It doesn't take a finance degree to know that higher incomes allow you to invest more money. If you're breaking into the workforce, don't let that dissuade you from putting money aside for savings. The power of compound interest will pay dividends if you can invest money while you're young.

Personal Debt

Debt is an essential part of the modern financial world. In fact, all money is debt. If you want to have a healthy investment portfolio, make sure to settle as much of your debt as possible.

Debt comes in all forms, including mortgages, college tuition, medical bills, auto loans, and credit cards. Making the minimum monthly payment on these debts will only keep you in a vicious cycle. Paying off each obligation can give you the financial freedom you need to invest freely.

Not sure which debts to pay off first? Check out Tally. The revolutionary app provides a debt robo-advisor that helps you eliminate debt and rewards you in the process.

Stocks vs. Bonds Allocation

While Warren Buffett advocates for a 90/10 stock-to-bond split, even he admits that the stock-to-bond allocation isn't for everyone. Many financial advisors recommend starting with more stocks when you're young. As you get older, shift your allocation toward bonds because they're less volatile.

You can think of your stock vs. bond allocation as 100 minus your age. If you're 25 years old, you should hold roughly 75% of your portfolio in stocks and 25% in bonds. When you reach 35, those numbers should shift to 65% and 35%, respectively. This process continues even after you retire.

Fees

It's almost impossible to overstate the importance of investor fees. A single percentage point can make the difference between retiring at 65 versus 68. While creating a robust portfolio comes first in investing, make sure you aggressively pursue low fees.

Consider this scenario. A millennial investor puts $25,000 in their retirement account and sets aside $10,000 a year with a 7% annual return for the next four decades. If that person pays 1% in investing fees, that decision will cost $590,000 over the next 40 years. The investor could make a wiser decision by selecting funds with lower fees and using robo-advisors instead of active portfolio management.

Your Health

Believe it or not, your physical health goes hand in hand with your bank account's health. Taking small steps to eat well and exercise regularly will save you tens of thousands of dollars over your lifetime. According to The New York Times, exercising 30 minutes a day, five times a week, is enough to save you $2,500 per year.

Your daily walk or dietary supplements might not seem like life-changing decisions. It's only after you combine all of your small positive actions that you realize the whole is greater than the sum of its parts. Your future self will thank you later, too, knowing that you have a lower risk for Type 2 diabetes, heart disease, and breast cancer.

Other Considerations

Every investor is unique. Someone who is 20 shouldn't invest in the same way as a 60-year-old. The 20-year-old should have a higher risk tolerance and a longer time horizon because retirement is distant. The 60-year-old investor should be more conservative, limiting their exposure to risk before retirement.

Some of the other factors to considerate when investing include:

  • Time horizon
  • Appetite for risk versus reward
  • Personal objectives
  • Employer-sponsored retirement plans
  • Rebalancing
  • Personal emergency funds

You're never too young to start investing. What's important is that you, first, have an emergency fund that lasts you for at least three months and, second, have no high-interest debts. If you pass those two tests, you have the green light to invest.

Bottom Line

If you're comparing small-cap value vs. growth, it's impossible to say whether one is superior to the other. Our examples show that, based on your time horizon, value can outperform growth and vice versa. There's no way of knowing unless you can predict the future.

Realistically, you should have some small-cap growth in your portfolio. It should not make up a majority of your investments, especially not over the long term. Check out our article on Large Cap vs. Small Cap Mutual Funds to learn more about maximizing your returns.


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