The following graph summarizes US market performance year-to-date. Positive performance has largely been driven by large, growthy companies (think Tesla, NVIDIA, Microsoft, Amazon, and Google). As you move away from those investments, you start to see more underperformance relative to the index, and even negative performance as you get into "small cap value."
It's been such a painful year that it's hard not to think of the "Midwit" (sounds like "Nitwit") meme, wherein a chronic over-thinker makes their life harder than it has to be (usually with a worse result). Lately, I've been feeling like that guy in the middle.
When a thoughtful, diversified, data-driven portfolio underperforms a single-holding portfolio, it's easy to make yourself crazy. Why own anything besides the S&P 500? Why work harder for a worse result?! Gaahh, I'm so STUPID!
But of course, that's not a great state of mind for making investment decisions. At times like this, it's good to remember why we got into this investment in the first place, and check whether that thesis is fundamentally intact.
Why do I own small cap value, ie the worst-performing market segment in the US in 2023?
If you look at the data, the smallest, cheapest cohort of stocks has historically produced higher returns than the largest, growthiest cohort. This tendency has been robust as far back as the early 1900s. This period has encompassed considerable technological, cultural, and societal change.
The argument against quantitative investing is that markets have adapted over time such that this opportunity no longer exists. Another argument is that the pace of technological change has widened the advantage for fast-growing, tech-forward companies.
Do these arguments cause me to lose sleep at night? Honestly? Yeah.
At the same time though, you could have made that same argument at any point over the last century, only to be dumbfounded when small cap value resurged once again. It isn't obvious that the technological advancements of the future will be any more revolutionary than the mass adoption of electricity, indoor plumbing, cars, commercial air travel, petroleum products, and computers.
Pain is what makes small cap value "work." It has long periods of underperformance, high volatility, and virtually no brand recognition for the companies you own. Often, small cap value "works" when people least expect it to. It then has one to three years of stellar performance, followed by several years of mediocrity. The risk to cutting this asset class is that you will miss one of those surges. The risk to staying in is a few more years of pain.
No one can deny that small cap value has had a rough decade, underperforming large cap growth by roughly 8% a year, according to Morningstar.com.
All throughout this decade, small cap value stocks have looked underpriced and destined for a rebound. But sadly, believers in "small cap value" have felt like Linus in "The Great Pumpkin Charlie Brown" refusing to let go of his faith that the Great Pumpkin will rise up out of the pumpkin patch.
And yet, while growth and value stocks appear to have started the year at similar discounts to fair value, growth stocks have closed the gap mightily, while small cap value has languished. Going forward, Morningstar sees large cap growth stocks as fully priced, while small cap value stocks trade at a substantial discount. In fact, the valuation spread between small cap and large cap stocks is as large as it has been in the last 20 years. So believing in small cap value probably isn't quite as delusional as believing in "The Great Pumpkin."
As someone who holds a lot of small cap value exposure in his portfolio, I would love to see that spread narrow for small cap value. Seeing that happen would mean not only strong returns, but outperformance vs the index.
A note of caution, however. Cheap stocks have mostly stayed cheap for the past decade. Small cap value, as a strategy, tends to own companies that aren't growing their value very much from one year to the next. These are low quality companies.
Meanwhile, growth companies usually are enhancing their value from one year to the next. A stock that is over-valued or fair valued today may grow into its valuation, or even become undervalued despite a stock price that has risen over that time. Those are the stocks you love to own.
The risk to large cap growth stocks is that they either slow down, or fail to live up to their high valuations. These are scenarios where you see large losing periods, sometimes for a decade or more, as happened after the dot-com bubble. The Nasdaq (ie, growth stock index) delivered negative absolute returns for a decade, mostly because stocks had reached such excessive valuations at the start of that period.
So if you're a small cap value investor, longing to forsake your value-investing ways, what do you do from here? Is now a good time to bail? I think the answer is mostly no. A decent time would have been in early 2021, although most of the rest of the market was overvalued at that time too. Today, small cap value as a strategy, and small cap stocks in general, are undervalued relative to their fundamentals. At least according to this graph from Morningstar.
For comparison, here is Morningstar's estimate of where tech stocks have traded relative to their "Fair Value." Tech stocks are a proxy for large cap growth, by the way. Keep in mind that large cap growth stocks appear to be fully valued, suggesting that any desire to rotate into them is more likely to do with FOMO rather than thorough analysis.
As you can see, tech stocks started 2023 undervalued, and then had great performance to close that gap. Small cap value, as you'll recall, also started out cheap. But it stayed cheap for a rather lackluster year.
That's how it goes sometimes in markets, and I think there are a couple lessons to learn here.
First, whatever strategy or investment plan you create, make sure you understand the risks. Don't just aim for outperformance or try to time the different strategies, but instead make a point of knowing what you're signing up for. Understand how long different strategies can underperform for, and make sure that your personal finances are prepared.
Whatever story comes with your investment choices, make sure you can stick to it through thick and thin, because every strategy out there will involve SOME pain. That's just the deal we accept when investing. With the NASDAQ, that pain may come in the form of a lost decade. For small cap value, that pain may mean a decade or more of underperformance.
But from what I've seen, any sensible strategy can produce wealth when you stick to it. Trouble comes when you try to hop from one strategy to the next. That's what costs investors the MOST money and causes them to underperform their own investments (which yes, is a real thing).
There's an old saying on Wall Street, "Bulls make money. Bears make money. Pigs get slaughtered." The idea is that there's no one way to invest, do whatever fits your style. However, if you're constantly changing styles by chasing short term results, you're going to suffer.
There's actually data to back that up (from JP Morgan Guide to Markets):
Most investors, left to their own devices, underperform their own investments. The trouble lies in trying to outperform those top several asset classes and in switching around whenever one investment struggles. There's usually very little rhyme or reason to their approach other than that they believe this or that investment will do well over the next 12 months.
A wiser approach, I think, is to invert that approach. Rather than trying to shoot the lights out over any 12 month period, what if we made it our goal to AVOID getting the poor result experienced by the average investor. Rather than concentrate everything in one asset class, what if we owned a basket of investments that have a high probability of delivering good returns over the next 20 years. We don't know in advance which ones will do best, but if we avoid betting everything on one investment, we're less likely to make dumb mistakes. The more we diversify, the better our odds of owning what works. Within reason.
The reason I include small cap value in my portfolio is not that I think it will outperform in every decade. Instead, I almost expect each investment in my portfolio to have a decade where it lags compared with everything else. The key is that I'm willing to stick with it through lean times so that I'm still around when it does well.
There's always going to be something shiny, luring me away from rational portfolio construction. But again, the goal isn't to guess what that big winner is and bet the farm on it, the goal is to minimize my chances of getting a poor result. And so I focus on what I can control, and let go of what I can't.