Should you still invest in small-cap stocks after their big gains?

Recent academic research, extending stock return analysis back to 1866, challenges the long-held belief in a statistically significant small-cap outperformance effect, suggesting prior findings were a data artifact from limited historical databases. While the Russell 2000 has seen recent gains, investors are cautioned against relying on size alone for returns. Instead, studies indicate that only 'high-quality' small-cap stocks—defined by profitability, growth, and low risk—demonstrate superior performance, necessitating a highly selective approach to small-cap allocations.

Analysis

Recent academic research leveraging an extended historical dataset back to 1866 challenges the validity of the traditional small-cap effect, suggesting the previously documented outperformance of smaller stocks was a statistical artifact of a more limited data period (post-1926). The analysis indicates that the small-cap factor fails out-of-sample tests for periods both prior to 1926 and after 1990, raising significant doubts about size alone being a reliable driver of excess returns. This finding is particularly relevant as the Russell 2000 (RUT) index has recently surpassed its November 2021 peak, a technical breakout that may not be supported by the long-term factor premise. Instead, research from AQR Capital Management highlights that performance within the small-cap segment is bifurcated, with 'junk' stocks (unprofitable, high-debt) dragging down the average. Superior returns are concentrated in 'high-quality' small-cap companies, characterized by strong profitability, profit growth, low stock-return risk, and high dividend-payout ratios. The article identifies specific companies such as TXNM Energy (TXNM), New Jersey Resources (NJR), Sabra Health Care REIT (SBRA), and DHT Holdings (DHT) as examples that fit this high-quality profile.

Key Decisions for Investors

• Investors should critically re-evaluate passive, market-cap-weighted exposure to the small-cap asset class, as the underlying premise of a 'size premium' is now in question based on long-term historical data.
• Portfolio allocation to small-caps should pivot from a broad-based approach to a highly selective, quality-focused strategy, screening for factors such as profitability, growth, low volatility, and dividend policy.
• Consider the recent technical breakout of the Russell 2000 with caution, as it may not signal broad-based strength, and instead focus due diligence on individual high-quality names like those mentioned (TXNM, NJR, SBRA, DHT) that align with a quality-driven investment thesis.