70 Times Better Than the Next Microsoft

I recently found this chart from the ever-helpful moneychimp.com:

Category	Value	Growth
Large Cap	12.4%	9.5%
Small Cap	15.4%	9.2%

Those are historical returns from 1927 to 2005, not adjusted for inflation. The terms "value" and "growth" are taken from data from highly respected researchers Fama and French.

That's a persuasive case for putting small-cap value stocks to work in your portfolio. (We'll get to just how persuasive later.) And you've probably seen plenty of other data showing that small caps outperform large caps, and value outperforms growth. Why, then, doesn't small growth outperform large growth? And why does small growth, on average, end up being the worst choice for your money?

Moneychimp.com offers a theory that I think is worth seriously entertaining, at least when it comes to how you invest in small caps. Just think about how investors might mentally categorize large- and small-cap value and growth companies. It might look something like this:

Category	Value	Growth
Large Cap	Well-known, boring businesses.	Well-known, exciting businesses.
Small Cap	Unknown, boring businesses.	The next Microsoft (Nasdaq: MSFT) is in here somewhere!

Thanks, Moneychimp. You're on to something.

What do value and growth look like?
What's the price difference between what might be "the next Microsoft" and the unknown and boring? Let's look at the data.

There's never been an official ruling on what separates "value" from "growth." There are dozens of ways to make those distinctions, and the data Fama and French produce comes from their own method of sorting out what makes a value stock and what makes a growth stock. Let's look at a more accessible listing of stocks, to give you an idea of what value and growth look like according to recent data. We'll take two of the holdings from each of the Vanguard small- and large-cap value and growth index funds.

Category / Stock	Price-to-Book	Price-to-Earnings
Large-Cap Value
ExxonMobil (NYSE: XOM)	3.3	9.6
Wells Fargo	2.0	13.8
Large-Cap Growth
Microsoft	7.0	15.0
Oracle (Nasdaq: ORCL)	5.2	22.1
Small-Cap Value
Ryder Systems	2.1	16.2
Harsco (NYSE: HSC)	2.6	14.8
Small-Cap Growth
ResMed (NYSE: RMD)	3.2	31.9
Affiliated Managers Group (NYSE: AMG)	3.0	21.1

These companies aren't selected to imply that any one or two is likely to do better than another over time. Instead, they're intended to show you what some of the larger players look like when you compare their price to both their book value and their earnings. Obviously, to justify their prices, those companies categorized as "growth" need to grow their earnings much faster than the companies in the value quadrants.

The numbers attached to these small-cap growth companies are particularly startling. That's not to say that ResMed and Affiliated Managers Group are necessarily overpriced, nor that they won't grow their earnings sufficiently to be good investments from here. But to the extent that they represent the expectations built into their other brethren in the small-cap growth field, we can see why the returns for the quadrant as a whole end up disappointing investors.

Taken as a whole -- as measured by thousands of companies, not just two -- small-cap stocks will be more inaccurately priced than large caps in the market, but not necessarily better-priced. The inaccuracies work both ways. Those that are historically overpriced (small-cap growth) tend to be more overpriced than their large-cap brethren, and those that are underpriced (small-cap value) can be more so than their large-cap cousins -- though as a group they are not at the moment.

What's the cost?
The rewards of being aligned with the right quadrant instead of the wrong one over 78 years are absolutely staggering. Compounded over those 78 years, $100 would translate to:

Categpry	Value	Growth
Large Cap	$898,967	$130,165
Small Cap	$7,307,903	$103,626

Is 78 years a relevant investment period? Well ... kind of. It's just slightly longer than an average American life span. So the difference between small-cap value and small-cap growth over a lifetime has been a multiple of more than 70 times the end result. That's right: 70 times. (So get started investing early, and start your kids' accounts now!)

There are literally thousands of companies in that small-cap value quadrant that you should be concentrating on, none of which can possibly be described as "the next Microsoft." They might not carry the wallop of a potential Microsoft over the short term, but over many decades, and taken as a group ... wow.

We spend every day looking for the next not-exactly Microsoft at Motley Fool Hidden Gems. Among others, we closely follow a manufacturer of clothing labels and a producer of components for manufactured homes (both are market-beaters). But you don't have to be an expert at finding the best ones in that quadrant, because the average returns have just been so monumental.

Remember that the next time you hear about how somebody has found the next Microsoft.

Copyright © 2008 Universal Press Syndicate.