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Unraveling the investment world: The case for small-cap stocks

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The S&P 500® has been the talk of the investment world in recent years. Since the Global Financial Crisis (GFC) in 2008-2009, U.S. large-cap stocks have delivered strong annualized returns, outperforming all other equity classes Frontier models and setting a high bar for asset class performance. However, small-cap stocks are viable contenders for long-term investment due to their valuations.

The performance of the S&P 500

The S&P 500 has been on an impressive run for over a decade, delivering a little over a 16% annualized return from the market bottom on March 9, 2009, through the end of 2023. The table below highlights its outperformance over all other major equity asset classes on both an absolute and relative basis.


Index return through December 31, 2023

The value proposition of small-cap stocks

Despite the historic performance of the S&P 500 over the past decade and a half, there seems to be a disconnect between past performance and forward-looking expectations. The reasoning? Valuations. Basing future return assumptions on past performance is generally not the best approach. Instead, valuations can be a more reliable predictor of future returns over long periods.

Understanding the data

As shown below, the Forward Price/Earnings ratio of the S&P 500 is well above that of the S&P 600 Index (representing US Small Cap stocks), even after the small cap index significantly outperformed the S&P 500 in December. Coming out of the Global Financial Crisis in 2008, small cap stocks traded at a premium to S&P 500 based on the forward P/E ratios. This has changed substantially over the last decade plus, and small caps now trade at a significant discount. Based on the data shown, an investor is willing to pay almost 40% more for a dollar of earnings in the S&P 500 than for that same dollar of earnings in the S&P 600.

Forward P/E Ratios

Source: Yardeni Research

Other metrics are also telling. The PEG ratio is similar to the P/E ratio except that it incorporates analyst expectations for future earnings growth.

Forward PEG Ratios for S7P 500/400/600

Source: Yardeni Research

The difference in the PEG ratios isn’t quite as high as the difference in PE ratios. Still, it paints a similar picture: investors currently pay a significantly higher multiple for exposure to the large cap index than the small and mid-cap indices, even when factoring in consensus earnings growth expectations.

The ultimate contrarian indicator

In what may be the ultimate contrarian indicator, Apple’s market cap, the largest publicly traded U.S. company, overtook the entire combined market cap of all the stocks in the Russell 2000 Small Cap Index earlier this year. Following suit, Microsoft has also achieved this feat, even as small-cap stocks in aggregate have declined to less than 4% of the total value of the U.S. stock market:

Small Caps now make up less than 4% of the total U.S. Stock Market

Source: Daily Chart Book

The expected risk and return

Another compelling argument in favor of future small-cap outperformance is their expected higher risk. Investment research generally asserts that small cap stocks have greater risk than large caps on average. Investors who support this assertion tend to agree that small-cap stocks are priced with the expectation of higher future returns to compensate investors for their higher expected risks. This has likely contributed to their significant long-term outperformance since the start of our longest strategy track record dating back to January 1999.


Growth of $100 investment

Source: Zephyr Style Advisor

Decisions based on research and experience

Investment decisions should be based on robust research and experience. Our process, refined through more than 20 years of managing money for our clients, focuses on what we believe to be the best predictors of future returns rather than relying on the simple assumption that what has outperformed in the recent past will continue to do so.

Our latest capital market assumptions call for attractive long-term returns for small-cap stocks, with expected outperformance relative to large caps both in the U.S. and internationally. However, this comes with more downside risk.

Downside risk and expected returns

Source: Frontier Asset Management For illustrative purposes only.
Expected Returns are hypothetical in nature and are not a guarantee of future performance. Any estimate or similar predictions of returns are based on assumptions and assessments made by Frontier that it considers reasonable under the circumstances. Frontier Asset Management calculates capital market assumptions at least monthly and sometimes more frequently if markets are exhibiting significant volatility. All data is represented on an annualized basis. Each asset class is associated with a unique expected time horizon, determined by the investment’s duration. Volatility and correlations are forecasted for a period of one year that includes inflation. While Frontier believes that these assumptions are reasonable, there can be no assurance that the results will be obtained. *Full 20-year expected return data is not available.

It’s important to note that these forecasts are long-term and don’t guarantee that small caps will outperform moving forward, particularly over the short term. But as long-term investors, we have a high degree of conviction in our process, backed by compelling evidence of its merits.

Investment success is as much about the journey as it is about the destination. It’s about striking the right balance between risk and return, guided by a meticulous and forward-looking approach. As a downside risk manager of globally diversified strategies, most of our investment offerings will typically include a mix of both small and large capitalization stocks in both U.S. and international markets. Our more conservative strategies will tend to favor large-cap stocks due to their lower expected downside risk, while our more aggressive, growth-oriented, equity-heavy strategies will favor small-cap stocks due to their higher expected returns over the long term.

As always, we encourage investors to consult with their financial advisors and consider their risk tolerance and investment goals before making any investment decisions. We look forward to accompanying you on your investment journey, providing the expertise and insights you require to make informed decisions.

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Past performance is no guarantee of future returns. Performance discussed represents total returns that include income, realized and unrealized gains and losses, but gross of advisory fees. Nothing presented herein is or is intended to constitute investment advice or recommendations to buy or sell any type of securities and no investment decision should be made based solely on the information provided herein. There is a risk of loss from an investment in securities, including the risk of loss of principal. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable or suitable for an s investor’s financial situation or risk tolerance. Diversification and asset allocation do not ensure a profit or protect against a loss. All performance results should be considered in light of the market and economic conditions that prevailed at the time those results were generated. Before investing, consider investment objectives, risks, fees, and expenses. Frontier may modify its process, opinions, and assumptions at any time without notice as data is analyzed.

Information provided herein reflects Frontier’s views as of the date of this newsletter and can change at any time without notice. Frontier obtained some of the information provided herein from third-party sources believed to be reliable, but it is not guaranteed, and Frontier does not warrant or guarantee the accuracy or completeness of such information. The use of such sources does not constitute an endorsement. Frontier’s use of external articles should in no way be considered a validation. The views and opinions of these authors are theirs alone. Reader accesses the links or websites at their own risk. Frontier is not responsible for any adverse outcomes from references provided and cannot guarantee their safety. Frontier does not have a position on the contents of these articles. Frontier does not have an affiliation with any author, company, or security noted within. Frontier reserves the right to remove these links at any time without notice.

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Any forward-looking statements or forecasts are based on assumptions and actual results are expected to vary from any such statements or forecasts. No reliance should be placed on any such statements or forecasts when making any investment decision. The estimates, including expected returns and downside risk, throughout are calculated monthly by Frontier and will change from month to month depending upon factors, including market movements, over which Frontier has no control. They are only one factor among many considered in Frontier’s investment process and are provided solely to offer insight into Frontier’s current views on long-term future asset class returns. They are not intended as guarantees of future returns and should not be relied upon in making investment decisions.

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Frontier’s use of external sources should in no way be considered an endorsement. Reader accesses sources at their own risk. Frontier is not responsible for any adverse outcomes from sources provided and cannot guarantee their safety. Frontier does not have a position on the contents of the site sources. Frontier does not have an affiliation with any author, company, or security noted within. Frontier reserves the right to remove these links at any time without notice.

It is generally not possible to invest directly in an index. Exposure to any asset class or trading strategy or other category represented by an index is only available through third-party investable instruments (if any) based on that index.

The hypothetical illustration is provided for informational purposes only. The example given does not consider the impact of advisory fees and the reduction they will have on the value of a managed portfolio. The hypothetical performance does not include taxes or other known or unforeseen fees and expenses that may be incurred by an investor. No investment decision should be made based on the illustration.

The forward price-earnings ratio (P/E Ratio) is the ratio of a company’s share (stock) price to the company’s estimated future earnings per share. The ratio is used for valuing companies and to find out whether they are overvalued or undervalued.

The price/earnings to growth ratio (PEG ratio) is a stock’s price-to-earnings (P/E) ratio divided by the growth rate of its forecasted earnings for a specified time period.

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U.S. Large Cap Equity S&P 500 Represents US large company stocks. It is a market-value-weighted index of 500 stocks that are traded on the NYSE, AMEX, and NASDAQ
U.S. Mid Cap Equity S&P 400 A stock market index that serves as a gauge for the U.S. mid cap equities sector.
U.S. Small Cap Equity S&P SmallCap 600 An index that covers roughly the small-cap range of American stocks, using a capitalization-weighted index.
International Equity MSCI EAFE A stock market index that is designed to measure the equity market performance of developed markets outside of the U.S. & Canada.
International Small Cap Equity MSCI EAFE Small Cap An equity index which captures small cap representation across Developed Markets countries around the world, excluding the US and Canada.
Emerging Market Equity MSCI Emerging Markets An index that captures large and mid cap representation across 24 Emerging Markets (EM) countries
U.S. Equity REITS FTSE NAREIT All Equity REITS A free-float adjusted, market capitalization-weighted index of U.S. equity REITs.



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