By Nathan G. Moser

Small-cap stocks, as measured by the Russell 2000 Index1, have outperformed large-cap stocks as measured by the S&P 500 Index2, by a significant margin over the long-term3. In fact, since 1926, small-caps' annual average total return of 16.7% has handily exceeded large-caps' 11.9% return, with small beating large in roughly two out of every three years during that period.3

Despite historical long-term outperformance by small-caps, many experts and market pundits continue to recommend an overweighting of largecap stocks relative to small-cap stocks. Their reasoning typically centers on large-caps' lower risk, inexpensive valuation and international exposure. In this report, I will discuss why I believe this reasoning is flawed and detail the drivers of what I believe will be small-caps' continued strong performance.

Small-cap stocks are often overlooked by investors due to their perception as volatile or risky choices. But investors who are willing to tolerate a higher level of risk may be rewarded with stronger longterm performance. In fact, during 2008-one of the worst years in stock market history-small-caps outperformed large-caps by more than 3% as investors learned that even large, well-known companies can go to zero. Small-caps have outperformed large-caps in 7 of the past 10 years and by approximately 40% cumulatively over that period. Furthermore, small-caps outperformed large-caps in every year in which major markets, as represented by the S&P 500 Index, lost value; twice
in the last 10 years.4 This resiliency runs counter to many traditional, long-held views of small-cap risk during broad market declines.

Valuation is often cited as a potential roadblock to continued small-cap outperformance. It's true that due to strong relative performance over the past decade, the Russell 2000 Index trades at a higher valuation5 than the S&P 500 Index6. However, when adjusted for small-caps' growth using the PEG ratio7, small-caps actually appear cheaper.8

I believe valuation is more of an art than a science. Just because a company or index appears "cheap" doesn't mean to me that it should be purchased, and, conversely, when valuation appears "expensive" it doesn't necessarily mean it should be sold. Valuation arguments are often imprecise and more representative of potential risk should expectations not materialize. In the case of small versus large valuation, the old adage "you get what you pay for" may hold true.

International Exposure
The case for investing abroad typically includes benefits such as diversification and stronger growth potential. While I am a believer in the benefit of some degree of international exposure, I would argue that investors can also be overexposed to international investments and, consequently, could have a higher level of risk in their portfolios than they realize.

The U.S. economy isn't without its challenges, but I am confident in our country's future. The innovation taking place in areas of technology and health care is breathtaking. I believe many smallcap companies are well positioned to participate in these exciting domestic growth areas and are levered to continued improvement in our U.S. economy. For this reason, I believe that small-cap stocks may be an attractive-and sometimes preferable-alternative to international stocks for investors interested in assembling a well-diversified portfolio with potentially less risk.

One view is that investors can reduce correlation9 and therefore risk by investing internationally. While this may have been true during the 1980s and 1990s, correlations have risen sharply over the past decade. Global capital markets and economies have become intertwined. Due in large part to technology, events on the other side of the world impact our markets and usually do so quickly. As shown in the chart above, the correlation between the S&P 500 Index and MSCI EAFE Index10 has risen from less than 0.5 to 0.9 (1.0 is perfectly correlated) since the mid 1990s. Over the past five years more than 1/3 of S&P 500 companies' revenues were derived abroad.11 If one factors in commodities, whose prices generally are driven by global demand-the S&P 500 exposure increases to nearly half. Many advisors characterize the S&P 500 as a domestic index, when a more fitting description might be a global index.

As the above chart shows, I don't believe as strong a case can be made as there once could that investing abroad lowers risk. There are several well-publicized issues ranging from increased violence in the Middle East and Africa to lingering debt concerns in Europe. Less publicized, but just as concerning to me are transparency challenges inherent in international investing such as corporate governance issues, accounting standards and investor protections. So, as with large-cap stocks, I don't think one's allocation to international stocks can reasonably be based on the premise that they offer lower risk, at least vis-a-vis small-cap stocks.

Now that I've attempted to address some of what I think are the common roadblocks to small-cap investing, I'd like to take a look at some of the current drivers that I believe may contribute to the continued outperformance of small-caps over large-caps: strong merger and acquisition activity and small-caps' performance during periods of rising inflation.

Mergers & Acquisitions
Due in large part to cost cutting and reduced capital expenditures, cash continues to build on corporate balance sheets. Cash held by non-financial U.S. corporations currently exceeds $1 trillion.12 Over the past three years, corporate managers have gone from thinking about survival to contemplating how to grow their businesses in a slow growth environment. I believe many companies are overcapitalized and will look to deploy excess cash in growth-enhancing acquisitions. The chart above shows the correlation between merger and acquisition (M&A) activity and the Russell 2000 Index from 2003 through 2011. In my view, the stock market leads deal activity. Should this relationship hold, I expect a re-acceleration in deal activity in the coming quarters. With the Russell 2000 Index within 14% of all-time highs,13 one could argue that we may see a near doubling in M&A activity, particularly if we return to 2006/2007 levels.

I expect the trend of most deals occurring in smaller companies to continue for a couple of reasons. First and foremost, while corporate managers have regained confidence recently, corporate board rooms still tend to be risk-averse settings. Small deals allow companies to spread risk through several transactions, use less capital and are easier to integrate. Second, small deals usually avoid the Federal Trade Commission (FTC) inquiry process which can impede or even derail a closing. While this may not seem severe to many, boards are generally very concerned with management distractions from running their core business.

Small Caps & Inflation
Inflation concerns have increased of late due to rising commodity costs and exceptionally easy monetary policy by the Federal Reserve. In this environment, many investors look to commodities and precious metals as a hedge against rising inflation. While I expect these assets will fare well in this environment, they have become popular or crowded investments. Any disappointment or reduction in inflation expectations could lead investors to all run for the exits at the same time. The last time the U.S. experienced meaningful inflation was the 1970's. Not surprisingly, gold was the best performing asset class.14 Small-caps were second with an 11% annual compounded return for the ten-year time period, outpacing the S&P 500 Index by more than 5% per year.14 The chart above details the Russell 2000 Index performance in 2011 above the 5-year forward, 5- year inflation expectation. There was a high correlation between rising inflation expectations and equity prices. Assuming this relationship holds, small-caps may fare well as inflation expectations increase.


Demographics will continue to impact markets as baby boomers retire and liquidate equities in favor of safer, yield-oriented instruments. This selling pressure will likely primarily be felt in large-cap, blue-chip equities which make up a large part of their portfolios. Arguably, part of the large-cap underperformance over the past decade is the start of this re-allocation, which I believe could continue for years. Small-caps' relative performance should, in my opinion, continue to benefit from this trend.

A large part of investing is managing the trade-off between risk and reward. Investors are generally willing to tolerate additional risk if compensated with additional return. The past decade has indeed been volatile, but investors who have historically included small-cap equities in their portfolios have been rewarded. While current small-cap valuations seem high by traditional standards, the market environment continues to be strong for small-cap strategies that are well-positioned to leverage the M&A opportunities, inflation and earnings growth expectations.

A thoughtful, active investment management strategy executed consistently during all market cycles is often the key to identifying opportunities and achieving strong long-term results. The Pax World Small Cap Fund focuses on high-quality companies with strong fundamentals, seeking particular value in innovative companies that are believed to be well-positioned to grow through all phases of the business cycle.

Visit for more information on the Pax World Small Cap Fund.

1The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000® Index is a subset of the Russell 3000® Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market
cap and current index membership. Investors cannot invest directly in any index.                                                                                                                                      

2The S&P 500 Index is an unmanaged index of large capitalization common stocks.
3Source - BofA Merrill Lynch
4Source: Factset as of 12/31/11.
5Valuation refers to the current worth of an asset.
6Source: Factset as of 12/31/11.
7PEG ratio is a stock's price/earnings ratio divided by its year-over-year earnings growth rate as of 12/31/11.
8Source: Factset as of 12/31/11. Russell 2000 P/E = 16X with long-term growth estimates at 15%. S&P 500 P/E = 13X with long-term growth estimates at 11%.
9Correlation is a statistical measure of how two securities move in relation to each other. Correlations are used in advanced portfolio management. Scale: 1=100%, 0=0%.
10The MSCI EAFE (Europe, Australasia, Far East) Index is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed
markets, excluding the U.S. and Canada. The MSCI EAFE Index consists of the following 22 developed market country indices: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom.
11Source: BofA Merrill Lynch as of 12/31/11.
12Source: Factset as of 12/31/11.
13Source: Bloomberg as of 12/31/11.
14Source: BofA Merrill Lynch from 1/1/1970-12/31/1979.

Nathan G. Moser, CFA, is the Portfolio Manager of the Pax World Small Cap Fund. Mr. Moser has been responsible for management of the Fund since its inception in 2008. Mr. Moser joined Pax World in 2008 from Citizens Funds, where he worked for six years, first as an equity analyst and then as portfolio manager. He started his career with John Hancock Funds, where he was an equity analyst. Mr. Moser holds a Bachelor of Science from Babson College, is a CFA charterholder and member of the Boston Security Analysts Society.