The Small Caps That May Be Holding Back Your Portfolio’s Returns

The stock market is off to a rocky start in 2022. Some shares have fallen more than others: Exhibit 1 shows how small caps have lagged large caps in 2021 and into 2022, at least when measured using Russell indices. However, a deeper look shows a subset of small cap stocks drove much of this underperformance. Small companies with high stock prices that lose money or generate little profit may be holding back your small cap portfolio.

The top detractors to the Russell 2000 Index performance in 2021 share a common trait: they have low to negative profits and trade at high relative prices. At the beginning of 2021, each of the five companies charted in Exhibit 2 had generated negative profits over the previous year and traded at price-to-book ratios that placed them in the highest relative price quartile of the market.

Looking more broadly, we can see negative 2021 returns across many small caps with low profitability—particularly growth stocks with low profitability, as shown in Panels A and B of Exhibit 3.

These stocks were the worst-performing segment by far among small caps in 2021. This follows a four-year streak when these names outperformed other small caps, which led some investors to wonder whether looking to valuation and profitability to make investment decisions was outmoded.

However, looking broadly across decades of returns in global markets, we observe that small cap growth stocks with low profitability tend to underperform over the long run. And for good reason. From a valuation perspective, paying a lot for a company that earns little profit is a good sign of a very low discount rate, and therefore a low expected investor return. Research has shown that when examining stocks by their size, price-to-book, and profitability characteristics, small cap stocks with the lowest profitability and highest relative price have experienced the lowest historical returns.¹ By seeking to avoid these stocks, one can improve the expected return of a small cap portfolio. Commenting on the body of research examining these stocks, Professor Robert Novy-Marx said, “The small unprofitable growth portfolios are … way less than the sum of their parts. They just do so badly in the data.”²

Dimensional seeks to avoid these stocks in our portfolios that invest in small caps, such as those shown in Exhibit 4. And while this is not the only way our small cap funds may seek to add long-term value, 2021 adds another year to our long-run track record of delivering small cap solutions that have outperformed both peers and index funds.