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The Comeback Power of Small Value Stocks

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Small Cap Stocks Comback

Written by: Dougal Williams | Vista Capital Partners

When he competed in the 1972 Olympics, 800-meter runner Dave Wottle already shared the world record for that distance. But hobbled by injuries, he was unable to train in the weeks leading up to the Olympics.

So when Wottle, wearing his signature golf cap, badly trailed the field at the 500-meter mark of the finals, it seemed impossible he’d repeat his past success. He trailed by so much, in fact, that television announcers wondered if he was seriously injured and might drop out of the race.

But Wottle didn’t drop out. Seemingly from out of nowhere, he began to reel in the other runners, one by one, to win the gold medal.

Small cap value stocks may be today’s investing equivalent of Dave Wottle—proven in the past, but badly trailing the field.

Can they stage a comeback?

A Bleak Ten Years

Recent performance makes this hard to fathom.

Over the past ten years, small value stocks have underperformed large growth stocks by more than 5% per year. Much of that underperformance has occurred within the past 12 months, when small value has trailed large growth by more than 20%.

Performance relative to large growth stocks over the past decade has been so poor, in fact, that 96% of all historical 10-year periods have been better for small value than the most recent stretch.

Now, this underperformance may seem extreme to many of our clients, as small value is just one part of a well-diversified portfolio. In constructing portfolios, we’ve already considered the likelihood of periods similar to what we’re witnessing today.

That’s why small value stocks are an important, but far from dominant, part of our portfolios.

A Winning History

Recent stumbles may lead investors to forget they’ve historically been rewarded for favoring small value stocks.

Don’t confuse these stocks with today’s market leaders such as Amazon, Google, and Microsoft. No, these are often overlooked and unloved stocks like Spirit Airlines, Bed Bath & Beyond, and American Axle & Manufacturing.

While not popular, they are attractive from a valuation standpoint: Investors demand higher compensation for owning these slower-growing, financially distressed, or otherwise riskier companies—pushing prices to low levels where future return expectations are high.

And those expectations have historically been realized. Since 1926, these smaller and lower-priced stocks in the U.S. have beaten their larger, expensively priced peers by nearly 5% per year. The performance edge is similar in international and emerging markets.

This reward seems fair compensation for bearing the risk of owning companies that occasionally—and dramatically—trail the field.

Reasons for Optimism

Just like Dave Wottle, small value stocks have staged remarkable comebacks before.

Consider the decade ending April 1939, when large, high-priced stocks returned 2% more per year. The subsequent ten years saw small value outperform by nearly 16% per year.

Or the decade ending April 1999, when small value lagged by nearly 6% per year. In a dramatic comeback, small value outpaced large growth by 14% annually over the next decade.

These historical examples illustrate how investors occasionally become so enamored of the market’s most popular stocks, they forget a fundamental tenet of investing: price matters.

We will never know in advance when this race will turn, but we do know that low prices pave the way for high future returns, and high prices inevitably lead to disappointment.

And, if history is any guide, it will likely be seemingly from out of nowhere.

Just like Dave Wottle’s Olympic comeback.

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