April 2020 – Are Small Caps Vulnerable?

Investors may wonder how well small cap stocks will hold up in coming months. After all, small caps are in general riskier than larger companies. Investors have over time been rewarded for bearing this risk, but will this hold true in the face of recession? We can rely on historical data to assess that question if we are confident that small cap characteristics have not recently deviated from long-term trends.

One metric is a company’s leverage, or the relative value of its debt. Small caps’ debt relative to total assets has remained relatively stable and similar to that of large caps since 1975. Small caps’ ability to service their debt has also been stable. We can also assess the trend in the proportion of small caps with negative earnings. Recently about 25 percent of small caps have reported negative earnings versus 5 percent of large caps, but this has also held true for decades.

By these measures small caps have not grown unusually vulnerable, so we can rely on long-run historical data to inform expectations for small caps. Data reveal small cap stocks have been de-listed annually from stock exchanges for “bad” reasons (such as bankruptcy) at roughly six times the rate of large caps, and that this rate for small caps has been higher around recessions.

But small cap investors can take heart; there has been no relation between the rate of de-listings and subsequent relative performance of small caps. Nine of the 16 years in which US small cap delistings exceeded 5 percent were associated with higher returns for small caps. This stands to reason because investors insist on higher expected returns for this asset class to compensate for the possibility that some companies may not survive.

All of this suggests that despite the sharp reversal in economic activity, investors are well served by maintaining a broadly diversified portfolio that includes small cap stocks.

*See box, page 30, for representative indexes.

Also in This Issue:

Quarterly Review of Capital Markets
The Pre-Retirement Checklist: Health Care
The High-Yield Dow Investment Strategy
Recent Market Statistics
The Dow-Jones Industrials Ranked by Yield
Asset Class Investment Vehicles