At the same time, value can also get very expensive and lose Ben Graham’s prized margin of safety. Just recall the shellacking that energy, materials and financial sectors suffered in 2008.
The Small-Cap Premium
Academic research indicates that small-cap stocks outperform the market over time. Yet once again, that research is being questioned now for a host of different reasons.
Skeptics point to the dramatic shrinkage in the universe of public equities over the past couple of decades: The number of public U.S. companies is about 50% smaller than it was in 1999.
The boom in both venture capital and private equity has driven this phenomenon. Venture-backed companies are waiting much longer to go public than they did in previous cycles. At the same time, private equity concerns are flush with cash they have to invest, thus they are gobbling up small-cap and mid-cap businesses.
Some believe that many of the best investment opportunities are no longer available in public markets. An investor who bought onetime small-cap Amazon after its 1997 IPO earned a return of about 800 or 900 times the IPO price. Contrast that to a 20-fold increase in Google since it went public in 2004 or the quintupling of Facebook since its 2012 IPO.
The trend of keeping start-ups private longer is only accelerating—there were recently believed to be about 260 so-called unicorn start-ups valued at more than $1 billion, according to CB Insights. At last year’s Inside Alternatives conference hosted by Financial Advisor in Las Vegas, iCapital managing partner Nick Veronis told attendees that today’s VC firms and private investors seem eager to “extract most of the value out of their portfolio companies” before bringing them public.
Much ink has been spilled on how the indexing boom drives up the prices of mega-cap growth companies, but some believe its influence on small-cap equities is even greater. That’s because they are less liquid and fund flows can drive even more extreme price swings in this sector.
Multifactor
It’s not clients’ risk tolerance that poses the biggest challenges to advisors but rather, in Lazaroff’s view, clients’ tolerance for tracking error. In recent years, their exposure to value and small-cap stocks has caused their portfolios to stray from the S&P 500.