Small companies crushed on the stock market

Stock markets around the world are hitting new highs, but for those investing in small companies, the last few years have not been easy. Large companies have dominated the top of the returns lists. It is generally believed that smaller companies, while riskier, can deliver better returns over time because they have more room to grow. But this is not always, if ever, the case.

While the headlines are dominated by giant investor darlings like NVIDIA, the stock market boom of recent years has been widespread. This is easy to prove. For example, about 70% of the companies in the S&P 500 index are hovering above their 200-day rolling average.

Although most stocks have joined the party, some have had a more enjoyable ride than others. This is illustrated by the difference in returns between the normal version of the S&P 500 index, i.e. the market-cap-weighted version (a larger company has a greater weight in the index) and the balanced version (all 500 companies have the same weight, 0.2%, regardless of size). So even though most stocks are going up, the biggest gainers are the large companies, like NVIDIA. While this is not uncommon, historically the top 10 companies have tended to lose out to the index. This is logical, because as companies get bigger, their growth is bound to slow down. So far, tech giants like Amazon, Apple and Google have defied the inevitable mediocrity and have outperformed the S&P 500 index average over the past 10 years.

The last time the average stock fell behind the S&P 500 index in a similar way was some years before the burst of the tech-bubble.

If the average company in the S&P 500 index has slightly underperformed the index, small companies have done downright terribly. The higher risk level of small companies has taken its toll in recent years:  they are more indebted and suffer more from inflation and rising interest rates. And small companies are often small for a reason. Even in a forest, not all trees grow tall, because there is not enough light or water for everyone. The fate of many companies is to remain as flat as a fern.



In yet another ominous twist, a similar underperformance of small stocks lasted for several years before the tech-bubble burst. The historical return of the Russell 2000 small-cap index with dividends has underperformed the total return of the S&P 500 index over the past 30 years, but the difference in returns is specifically explained by the gap created in recent years. Historically, the indices have moved more or less in tandem.

Nasdaq Helsinki, which has data for a slightly shorter period, also shows a similar phenomenon. Small companies, as measured by the returns of the OMXH Small Cap index, have performed poorly compared to the OMXH25 index, which covers large companies. The OMXH Small Cap includes companies of a few hundred million euros or less. The largest is currently Purmo, and the smallest are Lehto and Valoe, which are valued at a few million. Based on a short history, small companies in Finland have needed a stronger economic climate, such as in the late 2010s and during the pandemic stimulus, to beat larger companies in terms of earnings. 

On the other hand, the current situation is interesting for a stock picker. If the economy picks up, we could see a real rally in the stock market among the riskier smaller companies. Of late, small companies have actually outperformed large companies. One has to be careful with smaller companies, though, because all kinds of oddballs can be found among them.