Dueling Fools
July 14, 1999

The Biggie Smalls Duel
The Bear Rebuttal
by Warren Gump
([email protected])

To address the only real point in the Blue Chips Bull argument, David Dreman might be correct regarding methodology flaws in measuring small cap performance. I don't have a strong enough statistical background to strenuously combat specific points. What I do know is that throwing out the time period prior to 1935, when stocks were supposedly "illiquid," actually bolsters my argument.

If you take out those time periods, the data much more conclusively supports small-cap stocks. Instead of a 1.9 percentage point outperformance, small caps whip large-caps by 3 percentage points, 15.1% to 12.1%. That's a substantial difference when compounded year in and year out. By the way, are you wondering why large-cap advocates are whining about "methodology flaws" rather than pointing to studies showing the large cap outperformance? Could it be that there aren't any valid studies in the latter category?

Bill continues his argument by discussing the "timing" of when small cap outperformance occurs. Exclude these years here and those years there, and you will find that large-cap companies perform better than small-caps. Using that strategy, you could probably create a scenario where Boston Market (now mired in bankruptcy) outperformed Microsoft. If you exclude Microsoft's 10 best performing months and take out the 10 worst period for Boston Market, you will find that investors were better off in Boston Market. That type of analysis simply doesn't hold much water in my book. Investors don't get to exclude a good day here or a bad day there when they hold onto a security.

Then again, maybe Bill thinks he is a good enough market timer to figure out exactly when specific stocks or sectors are poised to outperform over certain periods. He will always be able to buy into a security the day it reaches its bottom and then sell once it hits a high-water mark. Before trying that strategy, you may want to be sure that you have wireless access to the Internet and your broker, because you'll always need to be in touch with market movements. No respites or market vacations for you. To try to be an effective timer, you can't ignore the market, even for short periods of time.

You'll also most likely be wrong just as often as you're right, if the performance of other market timers is any indication. On top of that, you'll incur trading fees and taxes that reduce your returns. Virtually all Fools know that timing the stock market is a game for the Wise to play and lose their money on.

Back to small caps, let's look at a little more data regarding their returns. Below are the number of times that certain asset classes have outperformed all asset classes (large company stocks, small company stocks, long-term corporate bonds, short-term government bonds, intermediate government bonds, treasury bills, and inflation) over various time frames. A "rolling" time period refers to consecutive year analysis. For example, a rolling five year period would look at returns from 1990-1994, 1991-1995, 1992-1996, and so on. This data, based on the years 1926-1996, comes from Ibbotson Associates, which is widely regarded as having the most comprehensive and thorough information:

Highest Performing Asset Class

               Small Caps    Large Caps  Other
One Year           31           14        26
Rolling  5 Year    37           19        11
Rolling 10 Year    35           17        10
Rolling 15 Year    44            9         4
Rolling 20 Year    49            3         0

As you can see, small cap stocks tend to be the highest performing asset class. While the evidence is somewhat murky over shorter time periods (when you may not want to have money invested in stocks at all), it clearly shows that small cap stocks have been the best place to invest over longer time frames. During 94% of the rolling 20 year time periods, small cap stocks have outperformed every other major asset class. That suggests to me that small cap investors are those willing to endure short-term price volatility in order to maximize long-term returns. With more than 30 years to retirement, I'm definitely in that camp.

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