Is the risk-reward trade-off broken? Historically smaller companies have higher stock price returns, but this relationship has faded since 2008. What happened and why aren’t investors being compensated for taking more risk?
Table 1.1 shows how small-cap stocks have performed relative to large-cap stocks since the Great Financial Crisis in 2007-08. There is more volatility associated with small caps, but only a small amount of return compensation. What’s going on? For contrast, I provide the same metrics before the GFC in Table 1.2 and Chart 1.2 below.
Table 1.1: Small vs Large Cap Since the Great Financial Crisis (GFC)
Small-cap barely outperforms and has more volatility (measured by standard deviation of stock returns). This reinforces the risk-reward dynamic. Chart 1.1 below shows this graphically. Note: SPY is the S&P 500 Index ETF (Large Cap proxy); IWM is the iShares Russell 2000 Index ETF (Small Cap proxy).
Chart 1.1: Small vs Large Cap Since the GFC
Table 1.2: Small vs Large Cap Pre-GFC
Over this time period, small cap outperforms significantly with the same difference in volatility. You were rewarded more for taking risk in the pre-crisis era. Chart 1.2 below shows this graphically.
Chart 1.2: Small vs Large Cap Pre-GFC
So what gives?
Why aren’t investors being rewarded as they were before the GFC in 2008?
The answer boils down to how companies raise money. When a firm is going to undertake a new project (called capital budgeting in the biz), the top brass has to decide whether to sell bonds to raise cash or to give up portions of their company (called equity) to raise cash. To do this, they need to weigh their options, so to speak.
Companies can minimize their cost of raising cash (called the cost of capital) by optimizing the following equation with respect to the weights of equity and debt.
Cost of equity = f(company size, business risk, reputation)
It should be noted that if a company goes bankrupt, they have no obligation to pay their shareholders anything. Period. The investor accepts the risk that his investment may go to zero in exchange for a bit more return. Investors in stock take risk and are paid in stock returns or dividends. Because of this, the cost of equity is always greater than the cost of debt.
Cost of Debt = f(credit conditions, company size, debt outstanding, business risk)
Debt holders are the first to be paid back should a company default. In exchange for this assurance, the company gets to borrow at a lower rate. Lenders, or buyers of the debt, receive less in return. Less risk, less reward.
In the case of both debt and equity, long-established companies, like IBM or Exxon Mobil, will have a lower cost of raising capital than a recently established tech start-up. This can also be called the Size Premium. This is why you should be compensated more for owning a small company’s debt or equity.
Large Scale Asset Purchases aka Quantitative Easing:
Chart 2.1: Treasurys and Mortgage Backed Securities owned by the Fed
When financial markets began to fail in 2008, the Federal Reserve of the United States stepped in and started buying up mortgage backed securities (MBS) and US Treasury Bonds in order to stimulate the economy by artificially lowering interest rates to allow easier borrowing for companies. Cheaper debt means more companies can borrow to finance new projects, growing consumption of capital goods; at least that was the plan.
They did this in several stages known as QE1, QE2, & QE3. Some were even forced to borrow cash from the Fed to send a signal of stability.
Borrowing from the [Fed], even on a confidential basis, has long been viewed as a sign of weakness, to be avoided if at all possible. … [The Fed] arranged for four of the nation’s largest banks — Bank of America, Citigroup, JPMorgan Chase and Wachovia — to take what were described as symbolic loans of $500 million each. (Sauce)
Where did this liquidity go? Big banks lent it out to the nation’s largest institutions, doing what they do best, making money. They borrowed from the Fed at wicked cheap levels and lent to corporations at a higher rate which was still well below historic borrowing rates. Everyone wins, right? But who were the biggest winners?
The amount of debt a bank is willing to lend a company is directly related to the size of their operations. The bigger the firm, the more they can borrow. So who got the lion’s share of the injected cash? Big business. Think Apple, Microsoft, Amazon, Berkshire Hathaway, Facebook, JP Morgan, Johnson & Johnson, Google, Exxon Mobil, Bank of America, Visa, etc.
To lower their cost of capital (WACC), companies took out debt, which was now the cheapest it’s ever been since at least 1962 (see Chart 2.1). But instead of financing investments in brick and mortar or research and development, they used it to purchase their own stocks.
This shifted the weights of debt and equity.
Returning to the Cost of Capital Equation:
- Cost of debt falls.
- Companies raise more debt.
- They use the debt to purchase equity
- Lower Cost of Capital
Chart 2.1: US Treasury 10-Year Yield since 1962
Through stock buybacks, companies were literally purchasing their own stocks to lower their weight of equity. The more stock they purchase, the more their stock prices rise. This brings me to the punchline: large caps are performing the same as small caps because of Quantitative Easing. This isn’t guesswork, it’s precisely what’s happening in financial markets worldwide. Until interest rates behave as they did in pre-crisis, pre-QE times, I don’t expect small caps on average to perform much better than large caps given the elevated level of risks.
Further, “the top 1 percent of Americans control 50 percent of the financial wealth, [thus] they gain the most when these asset prices boom” (Sharma, p. 108). In 2014, The Fed issued a statement, “our goal is to help Main Street, not Wall Street” (WashingtonPost), yet the Fed has been feeding inequality since. I don’t mean to be critical, but the Fed has to have realized that it had this effect.
I think the Fed did the best with what it had. When all you have is a hammer, everything looks like a nail. They saved many in the aftermath of the crisis, which I believe would have been much deeper without Federal Reserve intervention.
Bottom Line (TL;DR):
I’m long large-cap, high dividend stocks, for reasons stated in this article, as well as the tendency for high dividend stocks to outperform in rising interest rate environments. Here’s the source for that last statement: GlobalXFunds.
Thanks for reading, this was a fun one to write.
- NYT: The Fed’s Crisis Lending, Mar. 31, 2011. https://www.nytimes.com/2011/04/01/business/economy/01fed.html
- Sharma, Ruchir. The Rise and Fall of Nations. 2016.