70 Times Better Than the Next Microsoft
By Bill Barker (TMF Lazarus)
I recently found this chart from the ever-helpful moneychimp.com:
Value Growth
Large Cap 12.4% 9.6%
Small Cap 15.4% 9.3%
That's a persuasive case for putting small-cap value stocks to work in your portfolio. (We'll get to just how persuasive later.) And you've probably seen plenty of other data showing that small caps outperform large caps and value outperforms growth. Why, then, doesn't small growth outperform large growth? And why does small growth, on average, end up being the worst choice for your money?
Moneychimp.com offers a theory, and I think it's worth seriously entertaining, at least when it comes to how you invest in small caps. Just think about how investors might mentally categorize large- and small-cap value and growth companies. It might look something like this:
Value Growth
Large Cap Well-known boring businesses. Well-known exciting businesses.
Small Cap Unknown boring businesses. The next Microsoft is in here somewhere!
Thanks, moneychimp. You're on to something.
What do value and growth look like?
What's the price difference between what might be "the next Microsoft" and the unknown and boring? Let's look at the data.
There's never been an official ruling on what separates "value" from "growth." There are dozens of ways to make those distinctions, and the data that Fama and French produce comes from their own method of sorting out what makes a value stock and what makes a growth stock. Let's look at a more accessible listing of stocks, to give you an idea of what value and growth look like according to recent data. We'll take the two largest holdings from each of the Vanguard small-cap and large-cap value and growth index funds as of the end of November 2005.
Price-to-book Price-to-earnings
Large-Cap Value
ExxonMobil (NYSE: XOM) 3.5 11.5
Citigroup (NYSE: C) 2.2 11.1
Large-Cap Growth
Microsoft (Nasdaq: MSFT) 6.0 22.8
Procter & Gamble (NYSE: PG) 10.7 21.5
Small-Cap Value
Colonial BancGroup (NYSE: CNB) 2.0 16.0
Martin Marietta (NYSE: MLM) 3.1 20.9
Small-Cap Growth
Joy Global (Nasdaq: JOYG) 8.6 38.9
Intuitive Surgical 11.9 87.5
These companies aren't selected to imply that any one or two is likely to do better than another over time. Rather, they're selected to show you what some of the larger players look like when you compare their price to both their book value and their earnings. Obviously, to justify their prices, those companies categorized as "growth" need to grow their earnings much faster than the companies in the value quadrants. The numbers attached to these small-cap growth companies are particularly startling. That's not to say that Joy Global and Intuitive Surgical are necessarily overpriced, nor that they won't grow their earnings sufficiently to be good investments. But to the extent that they represent the other brethren in the small-cap growth field, we can see why the returns for the quadrant as a whole end up disappointing investors.
Taken as a whole -- as measured by thousands of companies, not just two -- small-cap stocks are going to be more inaccurately priced than large caps in the market, but not necessarily better-priced. The inaccuracies work both ways. Those that are overpriced (growth) will be more overpriced than their large-cap brethren, and those that are underpriced (value) will be more so than their large-cap cousins.
What's the cost?
The rewards of being aligned with the right quadrant instead of the wrong one over 78 years are absolutely staggering. Consider: Compounded over those 78 years, $100 would translate to:
Value Growth
Large Cap $898,967 $130,165
Small Cap $7,307,903 $103,626
Is 78 years a relevant investment period? Sure. It's just slightly longer than an average American life span. So the difference between small-cap value and small-cap growth over a lifetime has been a multiple of more than 70 times the end result. That's right: 70 times.
There are literally thousands of companies in that small-cap value quadrant that you should be concentrating on, none of which can possibly be described as "the next Microsoft." They might not carry the wallop of a potential Microsoft over the short term, but over many decades, and taken as a group ... wow.
Remember that the next time someone tells you about how they've found the next Microsoft.
