Dueling Fools
July 14, 1999

The Biggie Smalls Duel
The Blue Chips Rebuttal
by Bill Barker ([email protected])

As I expected, Warren and I are having a little trouble agreeing on what the data states about the long-term returns of small caps versus large caps. Readers, I hope, will accept that difficulty as an inherent element in this debate.

For the sake of argument, though, I'm just going to hand Warren victory as to his citation of the Ibbotson Associates study showing that small caps have outperformed large caps between 1926 and 1996 by nearly two percent. However, I'll only accept that data to the extent that I get to join Warren in asking readers to consider the ramifications of the mean reversion theory -- and in doing so, I conclude that small caps still owe a substantial amount of underperformance to large caps to even out the historical record.

That is, Warren's arguments cancel each other out. If small caps have outperformed large caps over the longer time period, and mean reversion is true, then large caps are still the ones that are (relatively) undervalued. Even though small caps have a period of substantial underperformance measured over the last 10 years, they still have (according to the Ibbotson data) a record of outperformance over the longer 70-year time period. Therefore, I conclude, the trend in favor of large caps' relative recovery has not run its course. I'm not going to press that argument too hard because, as I mentioned in my bull argument, it isn't clear that the data persuasively shows any underperformance over the long term by large caps in the first place.

Next, I'll have to take on Warren's declaration that, "Based on current market conditions, you would be crazy not to investigate small-cap issues." Warren's support for this statement is that the P/E for the S&P 500 is 28x this year's estimates, while the P/E for the S&P 600 is 20x estimates. He further backs this up by noting that earnings for the S&P 600 are expected to grow 16% this year and 28% next year. On the other hand, analysts foresee S&P 500 earnings growing 12% in 1999 followed by 9% growth next year.

This is a pretty good argument, and let me say that I'd be the first to be persuaded by it if I had any kind of confidence in the analysts' earnings predictions -- but I don't. This isn't some generic slap at "those Wise analysts" however, but rather a recognition that the earnings projections of large cap companies are much more accurate because there is so much more data associated with their operations. Because large caps are typically more diversified, better financed, followed by more analysts, and in businesses that have longer track records, it is simply easier to predict their earnings accurately.

Small cap companies typically are followed by only a few analysts, and these few are usually working for the brokerage houses that do the investment banking for the companies being followed. Thus, any compilation of small cap earnings estimates is inherently skewed to the positive side by slightly less than completely objective recommendations. I wouldn't be surprised if small caps aren't always accorded a higher growth rate than large caps if you're paying attention strictly to the analyst estimates. (Okay, okay -- I guess I did end up taking a swipe at "those Wise analysts." Sorry.)

Given small caps' unarguably greater degree of risk, the paucity of evidence to show that they provide more bang for the buck, and the current economic factors that lead to the presumptions in favor of large caps today, I'll stick with the big boys.

Next: The Small Caps Rebuttal