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Where Have All the Small-Caps Gone?

Small stocks are disappearing. That's partly because they don't work as well as they used to.

Once upon a time, there were small-cap stocks…

A lot more than there are today, anyway.

Right after college, I found myself on our firm’s small-cap research desk. It was a lot of fun – traveling all over the country to visit all kinds of interesting businesses that were minnows by public company standards.

A hard drive manufacturer in Colorado. A retirement home operator in Massachusetts.

Even an – ahem – electric car startup in Silicon Valley (you know the one)[1].

Today, there are about 25% fewer small-cap stocks on the market than there were back then.

The numbers are even more stark over a longer timeframe. There are about half as many U.S. stock listings today versus the peak 1996. An interesting research piece from Morgan Stanley this month points out that 90% of the stocks that have disappeared are small- and micro-cap companies.

The reason? It pays to stay private.

A few decades ago, going public was the only way to access growth capital past a certain level. That’s changed as venture capital and private equity funds have gotten fatter wallets. That’s changed what an IPO means today, and the kinds of companies that pursue them. The median time to IPO has more than doubled since 1996 – and the median offering size has ballooned from $30 million back then to $108 million last year.

What does that all mean for investors?

For starters, it means there are fewer stocks today than there used to be. And especially fewer small stocks.

The Wilshire 5000 Index only has 3,473 components today – there aren’t 5,000 U.S. stocks anymore.

That also brings up a question of adverse selection (i.e. does a smaller firm going public mean that it couldn’t raise capital in the private market?) and size factor underperformance:

Top:; Bottom: Morgan Stanley: Public to Private Equity in the U.S.

Top:; Bottom: Morgan Stanley: Public to Private Equity in the U.S.

The size factor, which suggests smaller stocks tend to do better than big stocks (if only because of an illiquidity premium) was an abysmal underperformer as listings rose in the 1980s and 1990s – and it’s failed to meaningfully right itself since peak IPO.

In other words, the biggest gains may actually come from the biggest stocks these days – in part because some of the most exciting equities are withheld from public investors until they’re already quite large.

That jives with what we’ve seen work this year: bigger has definitely been better for your portfolio in 2020.

And for now, that looks unlikely to change.

When do small stocks work? They're a great mean reversion trade following a market crash. Small stocks still lead out of market bottoms -- and that's was evident heading out of the dot com crash and the 2008 financial crisis, when smaller names did amazingly well. The trick was not owning them into the crisis.

In 2020, with the Fed pumping money into the system at full bore? Not so much.

[1]: No, TSLA was never properly a small-cap. But we stretched our investment universe back then, in part because of the limited names within it.

Postscript: My take is that all of the above also has a very big tie-in to the rise of passive investing since the late 1970s. In fact, the relative underperformance of the size factor lines up almost perfectly with the rise in passive investing. Put another way, the 401k killed the size factor.

Michael Green has what I think is the best take on active vs. passive right now: