Missing the Forest-and the Trees?

Few are using the “weighing machine”
When investors do buy individual stocks—retail investors in particular—many now use short-dated options, levered single-stock ETFs or thematic funds. These vehicles encourage short-term thinking and less scrutiny of the underlying value of the businesses they're buying. As Benjamin Graham famously said, "In the short run, the stock market is a voting machine. But in the long run, it is a weighing machine." When a short-dated option is used to “invest” in a company, little attention is paid to its long-term prospects. We believe today’s investing environment and new tools have encouraged, if not enticed, many into short-term thinking instead of “stepping on the scale” and focusing long term. The problem for passive strategies is that the forest cannot thrive without healthy trees.

Passive small-cap allocations lack quality control
One of the clearest examples of these issues is in U.S. small caps. Hundreds of billions of dollars are allocated to small-cap index funds despite a deterioration in the quality of many small-cap businesses. The traditional drivers of the small-cap risk premium—early-stage ventures, better growth prospects, higher cyclicality—may still be true for a subset, but the Russell 2000 has many perma-small businesses, unlikely to grow.

Despite small caps’ challenges, passive allocators still want full exposure to the asset class. This has created market distortion, with virtually as much capital flowing to poor quality small companies as great ones. Moreover, when many investors buy small-cap stocks individually, they gravitate to the riskier, lower-quality subset. The meme stock craze of 2021, and its reemergence today, is concentrated in small caps. We believe this focus on the riskier subset of small-cap stocks is misguided.

An active, quality-driven approach is critical
Our work has shown that over the past 30+ years, small caps have had lower returns with more risk than large caps, and we have recommended many times that people not allocate to our asset class, unless they've hired an active manager focused on quality.

Display 2 shows that a portfolio of quality small-cap stocks can generate superior returns. Over the past 30 years, the higher-quality subset of the Russell 2000® Index, as measured by return on capital, has outperformed both the S&P 500 and broader Russell 2000.

We believe passive investing and lottery-style behavior have led to valuation distortions in small caps. Interestingly, in past story-driven markets—like the Nifty Fifty¹ era and the tech bubble—we also saw a relatively low valuation for quality small caps.

Today, however, a significant valuation gap has emerged, with profitable small caps markedly cheaper than large caps, creating a compelling investment opportunity (Display 3).

Bottom line: In our view, the proliferation of new equity investment instruments has encouraged short-termism and weakened investor insight into benchmarks and their diverse, individual components. We believe significant value can be added by investing in differentiated and durable companies. Historically, this quality approach to small-cap investing has delivered attractive risk-adjusted returns, and we believe today’s current valuations point to a compelling, possibly generational, opportunity.

¹ The term “Nifty Fifty” refers to a group of 50 large-cap stocks on the New York Stock Exchange popular in the 1960s and 1970s. Often referred to as “one-decision” stocks, they were highly favored by institutional investors for their solid investment characteristics. The stocks’ popularity led to inflated valuations, and many experienced sharp declines in the market downturn of 1973-74.