Why intelligent investors avoid small caps

Overview

Do the stocks of companies whose market capitalisations are relatively modest (“small caps”) outperform “large caps”? During the 1980s and 1990s, finance academics’ conventional – indeed, foundational – wisdom was unequivocal: they generally did. The “size premium” therefore became a fundamental “factor” underpinning stocks’ pricing, and was incorporated into influential models. Most notably, along with market risk and value premiums, in 1992 it created the Fama-French three-factor model.

By the early-2000s, however, this strong academic consensus had weakened considerably. Research published since then has increasingly concluded – and now broadly concurs – that over the past 30-40 years the “small-cap premium” has at best been feeble and inconsistent, and has usually been a discount.

In this article, I use widely-accepted and utilised American data further to revise the current conventional wisdom about small cap stocks. Academics presently concur, broadly speaking, that (1) from the mid-1920s to the 1980s they typically outperformed large caps but (2) since the 1990s have usually underperformed. I corroborate this result, and also demonstrate:

1. Because research typically defines small caps in relative rather than absolute terms, its major source of data has mislabeled as small caps what are actually micro-caps. It’s also overlooked micro-caps’ low liquidity and consequently high transaction costs – and thereby overstated the returns of what it mistakenly regards as small caps.
2. Correcting this mislabeling (that is, defining small caps conventionally) and considering their risks, over all intervals from 1926 to 1989 they tended to outperform mid-caps as well as large caps; conversely, over all intervals since 1990 they’ve generally underperformed both mid-caps and large caps.
3. Over short-term (12-month), medium-term (five-year) and long-term (10-50 years) intervals since 1926, small caps have typically outpaced “growth” stocks; equally, however, “value” has outperformed both small caps and growth.

Indeed, the longer is the interval the higher becomes the probability that value significantly outperforms small caps and growth (see also Want to shrink your returns? Buy “growth” stocks! 23 March).

These results’ implications are crucial, practical and topical. They hardly mean that Leithner & Company automatically reject a company from consideration simply because its market cap is less than $2 billion. Indeed, if you’re an investor and were forced to choose between two portfolios (one of which comprised 100% small caps and the other 100% “growth” stocks) and hold it for any period of time, you’d pick the small caps.

But if you could choose freely, you’d avoid “growth” like the plague and weight your investments exclusively towards value. On that basis, you’d mostly avoid small caps.

The Small Cap Premium’s Dissolution

Today, finance academics acknowledge that some (e.g., “high-quality,” value, etc.) small cap stocks may excel. Equally, however, they mostly agree that small caps as a whole no longer outperform large caps. They therefore accept, tacitly if not explicitly, that the “size premium” has vanished. Moreover, a few suspect that it never existed: it was an historical anomaly driven by outliers.

“You are neither right nor wrong,” Benjamin Graham famously wrote in The Intelligent Investor, “because the crowd disagrees with you. You are right because your data and reasoning are right.” Accordingly, where logic and evidence disconfirm mainstream views, as they often do, I reject them. Equally, however, when facts and reason affirm the consensus, I accept it.

Consequently, but unlike their advocates, I accept much of today’s academic consensus about small caps.

In The myth of the small cap premium (4 November 2021), I acknowledged that under certain infrequent conditions – which I specified – speculators who buy small caps can generate outsized short-term returns. However, I added a crucial caveat: investors should choose their small caps carefully and in moderation, and concentrate upon mid- and large caps.

In The myth of small-cap outperformance (14 July 2023), I added: “’investing’ in Aussie small-caps is like gambling: the longer you play and the bigger is your bet, the more you’ll underperform the house.”

Why Did Small Caps Once Outperform? Why, Insist Their Advocates, Do They Still?

The assertions of today’s small cap advocates (which include some advisors and funds managers, and a vociferous band of speculators) lag years behind the evolution of markets and the academic literature. On that flawed basis, small caps’ alleged outperformance, their boosters assert, is a consequence of at least four factors:

#1: Compensation for Risk

Small companies offer higher risk-adjusted returns in order to compensate for risk – that is, the higher volatility of their shares’ prices, the shares’ lower liquidity and the companies’ greater risk of bankruptcy. Small-caps offer higher potential growth; equally, their financial resources are more limited and their sensitivity to economic downturns is greater. If you want higher returns, you must accept greater risk. That was a basis of the academic orthodoxy which prevailed from the 1960s to the GFC.

Value investors, on the other hand, have always rejected the claim that higher risk must accompany higher return.

Instead, they contend that the most attractive investments offer both low risk and high potential reward. According to Benjamin Graham, higher returns result from added effort (increased research and analysis) rather than additional risk. The way to achieve superior returns, Seth Klarman maintains, is by shunning risk – not accepting it. Leithner & Company agrees (for a description and analysis of its management of risk, see To lift your returns, swap these risks, 9 December 2024).

Finally, Warren Buffett has stated that risk derives ultimately “from not knowing what you’re doing,” and particularly by overpaying.

#2: Higher Growth Potential

Small cap companies’ revenues and earnings are almost invariably much lower than large caps’. As a result, small caps can more easily lift their sales and profits; in contrast, large caps’ sheer size and market dominance constrain their growth. Small companies can also disrupt industries, innovate and expand their market shares in ways and at rates which larger competitors typically can’t match.

As I demonstrated in Want to Shrink Your Returns? Buy “Growth” Stocks! (23 March), small caps’ higher growth, if it exists, provides no reason to believe that they’ll excel. Quite the contrary: it provides strong grounds to expect that they’ll underperform.

#3: Sparse Research and Market Inefficiencies

Small caps, their advocates commonly assert, are under-researched: significantly fewer “analysts” cover a typical small cap than the typical large cap. This comparative lack of attention, boosters add, may create new or exacerbate pre-existing market inefficiencies; and the consequent mispricing may allow attentive managers and investors to identify and purchase underpriced companies (and sell overvalued ones) before others detect these disparities between price and value.

Those claims overlook a crucial fact: over the decades the number of Chartered Financial Analysts and other analysts has grown rapidly. The number of active CFAs has skyrocketed from 268 in 1963 (when 284 candidates sat the first CFA Institute exam) to more than 200,000 today. That’s a compound rate of growth of more than 11% per year, and since 2012 the total has compounded ca. 5% per year. Meanwhile, as I showed in Figure 1 of Want to shrink your returns? Buy “growth” stocks! (23 March), since the 1990s the total number of companies listed on American exchanges has halved.

It’s therefore increasingly likely that, as time has passed, small caps have become much better researched – and the market inefficiencies which allowed small caps to excel, if they ever existed, have weakened or disappeared.

#4: Acquisition Potential

Given that small caps can increase their revenues and earnings more quickly than large caps, small caps can become acquisition targets for larger firms looking to expand their product offerings, enter new markets or acquire technology rather than develop it internally. Those who hold these smaller companies can benefit from a significant premium price when a larger company acquires them.

Data

Series of valid, reliable and detailed stock market data are much longer in the U.S. than elsewhere. For this reason, I’ve analysed data compiled by Kenneth French and his colleagues (see also Why value investing crushes momentum speculation, 9 February, Why we’ve never held tech – and have long owned energy, 2 March and Want to Shrink Your Returns? Buy “Growth” Stocks! 23 March). For each month beginning in July 1926, they rank-ordered each company listed on AMEX, NASDAQ and/or NYSE according to its market cap on the preceding 30 June.

French et al. then assigned each company to one of three categories: (a) those ranked within the lowest three deciles (that is, the 30% of stocks whose market caps are lowest) to the “small cap” category; (b) those in the four middle deciles to the “mid-cap” category; and (c) those ranked within the highest three deciles (i.e., the 30% of stocks whose market caps are highest) to the “large cap” category. Finally, they computed each portfolio’s monthly total (that is, including dividends but excluding tax, brokerage and other costs) return.

Two Definitions: One Explicit and the Other Tacit

What is a small cap stock? A mid cap? A large cap? How to distinguish one from the others? According to Investopedia, (“Small-Cap Stocks: Definition, Investment Potential, and Risks,” 9 October 2025), “a small-cap stock is a company with a market capitalization between $250 million to $2 billion. The precise figures used can vary among different brokerages …”

Table 1 summarises widely-accepted cutoff points. Surprisingly, given the $A/$US exchange rate and often vast differences of market caps in the two countries, the American and Australian rules of thumb differ little.

Table 1: Common Rules of Thumb, Micro- to Mega-Caps

It’s a crucial point, and I’ll clarify its consequences subsequently: French et al.’s data tacitly define small, medium and large cap stocks in relative rather than absolute terms.

By their implied conception, over time there are no exact and constant dividing lines (as there are in Table 1) which separate small caps from mid-caps, and mid-caps from large caps: instead, the three lowest deciles 30% of all listed (on the AMEX, NASDAQ and/or NYSE) stocks ranked according to market cap are small caps, the top 30% are large caps and the remaining 40% are mid-caps.

In French et al.’s data, the ratio of small caps, etc., to all stocks is invariant, but the dividing line between these categories changes monthly.

Preliminary Results

Very Long-Term Compounding of Cumulative Returns

Figure 1 plots the total, CPI-adjusted value per $1 invested in the three portfolios in July 1926. Each $1 invested in the small cap portfolio grew to $2,945 in January 2026. That’s a compound annual growth rate (CAGR) of 8.4% per year. Each $1 invested in the mid-cap portfolio in July 1926 has grown to $2,867. That’s a CAGR of 8.3% per year. Each $1 invested in the large cap portfolio has grown to $847 (CAGR of 7.0%).

Over this 99.5-year interval, small have greatly outperformed large caps, but so too have mid-caps; yet small caps have barely (and seemingly insignificantly) outperformed mid-caps.

Figure 1: Total, CPI-Adjusted Value per $1 Invested, Three Portfolios, July 1926-January 2026

Short-Term, Medium-Term and Long-Term Returns

I’ve calculated the three portfolios’ CPI-adjusted total returns (expressed as CAGRs) over all rolling short term (12-month), medium-term (60-month), long-term (120-month) and very long-term (20, 30, 40 and 50 year) intervals since July 1926. For good measure, I’ve also calculated the S&P 500 Index’s CAGRs. For the sake of brevity, I’ve omitted the details.

Over all intervals, the small cap portfolio’s average CAGRs barely or at best modestly exceed the mid-cap’s averages. Small caps’ returns outpace the S&P 500 Index’s by bigger margins – and greatly exceed the large cap portfolio’s average CAGRs.

Broadly speaking over the past century – but taking into account neither the variability of their returns nor any differences before and since 1990 – small cap stocks have apparently outperformed large caps.

Three Reasons to Doubt That Small Caps Outperform

Figure 2, which plots small caps’ short-term (12-month), medium-term (60-month) and long-term (120-month) CPI-adjusted total returns, uncovers major anomalies in French et al.’s data: short- and medium-term returns during the 1930s and 1940s – and as recently as 2021 – are implausibly high.

Figure 2: Small Caps’ CPI-Adjusted Total Returns (CAGRs), July 1926-January 2026

Did small caps’ average, total CPI-adjusted return in the 12 months to June 1933 really skyrocket 437% (versus the S&P 500 Index’s 151.3%)? Did they zoom another 319% (versus the Index’s 81.7%) in the year to February 1934, 183% (83.7%) in the 12 months to March 1936, 139% (48.7%) in the year May 1943 – and 121% (46.9%) in the year to March 2021? Medium- and long-term returns which seem improbably high also occurred during the 1930s, 1940s and 2020s.

Academics have been aware of these anomalies since the 1980s – and have largely ignored them.

In Contrarian Investment Strategies: The Next Generation (Simon & Schuster, 1998), David Dreman explained them: academics – and as a result, small cap enthusiasts, including funds managers, et al., who, directly or indirectly have touted this research in order to justify their advocacy – “have completely overlooked how illiquid the market was in the 1930 to 1945 period.”

This extreme illiquidity, plus researchers’ patently absurd assumptions, have generated these implausible returns.

The market for small companies’ shares during the 1930s, Dreman’s enquiries during the 1980s discovered, was so thin that many small cap stocks – many of whose prices plunged well below $1 – traded at most only a few hundred shares per week. Indeed, over long stretches many didn’t trade at all. Moreover, the spread (difference between the highest price a buyer was willing to pay (bid) and the lowest price a seller will accept (ask)) was enormous.

People occasionally say: “I wish I’d been alive at the nadir of the Great Depression – I’d have spent everything I had on stocks, and made an absolute killing.” The truth is that very few people would have sold to you: shares were so illiquid that you could’ve bought mere handfuls only by accepting massively higher prices.

Extreme illiquidity produces enormous bid-ask spreads. According to Dreman’s calculations, derived from daily market data published in The New York Times, small cap spreads during the 1930s averaged an astounding 45%. Massive spreads, in turn, mean huge transaction costs. “That’s right,” he elaborates: “if you wanted to buy a stock at market … your cost went up 45%.”

But virtually nobody wanted to buy these stocks: “the average volume for the smallest (quintile of stocks listed on the NYSE and ranked by market cap) was 240 shares a day though the period.”

It’s important to emphasise: at the depths of the Great Depression, equity markets – and in particular the market for small caps – were extremely illiquid. Shares of small cap companies couldn’t be easily or quickly converted into cash without significantly impacting their market price. Yet researchers have simply ignored this reality.

Not only have they falsely believed that a buyer could effortlessly purchase large quantities of small caps; even more fancifully, they’ve also assumed that a buyer could buy these large quantities without affecting its price.

According to Dreman, small cap researchers “took a price between the bid and the offer price and did not consider that, (given) the gigantic spread and low volume, the price was completely theoretical. (They) simply assumed that (a small cap) stock could be bought or sold in the middle of the spread …”

Naively, researchers have taken extremely low market prices, the half-way point of a huge bid-ask spread, ignored extremely low volumes, and voilà – an enormous but implausible (indeed, entirely fictitious) return emerges!

Small caps’ extremely low volumes, massive spreads and resultant exaggerated and fictitious returns provide one reason why I doubt “small caps” – as French et al. define them – outperform.

Indeed, according to Edward McQuarrie (“Do Factor Strategies Beat the Market? Sometimes Yes. Sometimes No,” SSRN 5098799, January 2026), nearly all of small caps’ excess return over the past century occurred during only four years: 1933, 1943, 1945 and 1967.

My first criticism applies mostly to the 1930s and 1940s; my second one – French et al.’s inadvertent mis-labelling (compared to the consensus definition) of micro-caps as small caps – applies to all but very recent decades.

Recall that the consensus definitions of small caps, mid-caps and large caps, unlike French et al.’s implicit definition, impose clear and constant boundaries to distinguish one category from another. Summarising data which I downloaded on 18 March, Table 2 quantifies their implications: almost three-quarters of the stocks presently listed on the ASX are micro-caps. Another one-fifth are small caps, little more than one-twentieth are mid-caps and just one in 42 is a large cap. These percentages differ dramatically from French et al.’s.

Table 2: Categories of All Listed Companies, Micro- to Mega-Caps, Australia and the U.S. (18 March 2026), Billions of Dollars

So do the percentages of micro-caps, etc., listed on the AMEX, NASDAQ and NYSE. Recall that since 1926 French et al. have defined small caps as the lowest three deciles (30%) of stocks, ranked by market cap, listed on these exchanges.

What French et al. regard as small caps are actually, by the consensus’ definition, micro-caps. Similarly, most of the stocks which they regard as mid-caps are, by the conventional definition, small caps.

It’s therefore likely, given micro-caps’ relatively illiquidity, that French et al.’s data over-estimate the returns of what they mislabel as small caps. Their data enabled me to investigate and correct this disparity. I adjusted market caps for CPI and compared them to the consensus definition.

Figure 3a confirms that, almost without exception until the turn of the century, the CPI-adjusted market caps of the stocks which French et al. label as small caps was less than $300 million – and thus, by today’s consensus definition, were actually micro-caps.

Figure 3a: CPI-Adjusted Market Cap (Millions of $US), French et al. Small Cap Portfolio, July 1926-January 2026

Similarly, Figure 3b shows that, without exception until ca. 2000, the CPI-adjusted market caps of the stocks which French et al. label as mid-caps was less than $2 billion – and thus, by the conventional definition, were actually small caps.

Figure 3b: CPI-Adjusted Market Cap (Millions of $US), French et al. Mid-Cap Portfolio, July 1926-January 2026

Finally and in contrast, Figure 3c confirms that, mostly since the 1950s and without exception since the 1980s, the CPI-adjusted market caps of the stocks which French et al. label as large caps has been at least $10 billion – and thus, by the consensus definition, were large caps.

Figure 3c: CPI-Adjusted Market Cap (Billions of $US), French et al. Large Cap Portfolio, July 1926-January 2026

Hence the third major reason I doubt that small caps – as French et al. define them – outperform.

At what market cap does liquidity become an issue? At what minimum level, in other words, can a buyer reasonably easily buy a stock without affecting its price? My assessment (which is hardly comprehensive) concludes that liquidity issues typically become significant when market cap falls below $100 million-$300 million, and they usually become critical when capitalisations fall below under $50 million.

Recall from Table 2 that the average market cap of America’s micro-caps – which French et al. regard as small caps – is presently ca. $86m. Now review Figure 3a.

The inference is clear: the low liquidity of micro-caps can artificially inflate their reported performance; it creates the appearance of higher returns while often obscuring significant risks and large transaction costs.

Adjusting French et al.’s Data to Revise the Mainstream’s Key Claims

French et al.’s data enable us to correct these weaknesses. Specifically, it disaggregates companies’ market caps into ten deciles. For each decile (for brevity I’ll omit description of the complexities), I 

1. calculated the CPI-adjusted medium-term (rolling 60-month) return and the CPI-adjusted market cap of the companies generating that return;
2. merged the ten deciles into a single series;
3. ranked it according to market cap at the end of the 60-month period;
4. excluded (on the grounds that they’re illiquid micro-caps) the returns generated by companies whose average market cap was less than $300 million;
5. divided the series into three strata: returns generated by companies whose average market cap was (a) at least $300 million but less than $2 billion; (b) at least $2 billion but less than $10 billion; and (c) at least $10 billion.

Short-Term, Medium-Term and Long-Term Results

Figure 4 plots the results. Having removed illiquid micro-caps whose huge spreads inflate their estimated returns, small caps’ returns by the conventional definition are lower than by French et al.’s. In particular, results from the Great Depression and Second World War are less extreme.

Comparisons to Figure 1 are instructive:

• In Figure 1, small caps’ average, total, CPI-adjusted return in the 12 months to June 1933 skyrocketed 437%; in Figure 4 they zoomed 234% (versus the S&P 500 Index’s 151.3%);
• In Figure 1, in the year to February 1934 they zoomed another 319%; in Figure 4, it was 126% (versus the Index’s 81.7%);
• In Figure 1, in the year to March 1936 they increased another 183%; in Figure 4, it was 116% (83.7%);
• In Figure 1, in the year to May 1943 they increased another 139%, and 121% in the year to March 2021; in Figure 4, the corresponding percentages are 57% and 94%, and for the Index are 48.7% and 46.9%.

Figure 4: Small Caps’ CPI-Adjusted Total Returns (CAGRs), 1927-2026

Table 3 summarises results over all intervals – and compares them to the original data. Under the conventional definition and over all intervals, small caps outperform large caps. Equally, small caps’ short-term (12-month) and medium-term (five-year) returns fluctuate more than large caps’ – and by this measure are somewhat riskier. Over intervals of 10 or more years, however, small caps aren’t generally riskier than large caps.

Table 3: CPI-Adjusted Total Returns (CAGRs), Two Definitions, Three Portfolios and Seven Intervals, July 1926-January 2026

Crucially, however, under the conventional definition and over all intervals, on average small caps just barely outperform mid-caps. Moreover, small caps’ short- and medium-term returns fluctuate more than mid-caps’.

Compared to mid-caps, small caps don’t offer higher short- and medium-term returns; over these intervals they do, however, generate higher risk.

Small Caps’ Relative Performance Isn’t Cyclical

Stocks’ CPI-adjusted long-term total returns, as represented by major indexes such as the Standard & Poor’s 500 and All Ordinaries, are cyclical and mean-regressing. In plain English, this means that periods of significant outperformance (booms) presage periods of material underperformance (busts). Moreover, periods of relative outperformance (such as when one Index such as the S&P 500 outperforms another (All Ordinaries) beget periods of relative underperformance (such that the S&P 500 underperforms the All Ords; see, for example, Australian versus American equities: past, present and future, 24 November 2025).

Similarly, the relative performance of “value” versus “growth” portfolios has been strongly cyclical and mean-regressing. Although growth has recently dominated, historical data over the past century demonstrate that these cycles have turned – such that over rolling 20-year periods value crushes growth (for details, see Want to shrink your returns? Buy “growth” stocks! 23 March 2026).

The returns of small cap relative to mid- and large cap stocks haven’t been cyclical and mean-regressing – at least not in the same way as has been the returns (relative as well as absolute) of value and growth portfolios, and stocks overall.

Figure 5: Small Caps’ CPI-Adjusted, Five-Year Total Returns (CAGRs) Net of Mid-Caps’ and Large Caps’, July 1931-January 2026

Figure 5 plots the rolling, CPI-adjusted five-year total returns (expressed as CAGRs) of small cap relative to mid-cap stocks, and of small cap relative to large cap stocks. In the 60 months (five years) to July 1931, for example, small caps’ CPI-adjusted total return was -0.1% per year. Mid-caps’ corresponding CAGR was 8.3%; hence small caps’ return relative to mid-caps’ was -0.1% - 8.3% = -8.4%, and so on for each month to December 2025.

Given the results in Figure 3c, not until August 1959 is it possible to compute small caps’ returns relative to large caps. Percentages greater than 0% quantify small caps’ outperformance; percentages less than 0% denote their underperformance.

Small caps’ relative performance hasn’t been cyclical; instead, over the past century it’s weakly but steadily and statistically significantly deteriorated. Small caps’ returns relative to mid-caps and large caps have been trending downwards – albeit weakly but nonetheless statistically significantly – since, respectively, 1931 and 1959.

Figure 6 reveals a stark disparity before and since 1990: before 1990, small caps outperformed mid-caps and large caps; since then, they’ve underperformed. They’ve also underperformed since the GFC (March 2009) and COVID-19 (April 2020).

Figure 6: Small Caps’ CPI-Adjusted, Five-Year Total Returns (CAGRs) Net of Mid- and Large Caps’, Means over Four Intervals

It’s possible that over some subsequent medium-term (60-month) interval small caps will outperform mid-caps and large caps. Yet such a thing hasn’t regularly occurred since the late-1980s, and it’s been largely absent since the GFC. This fact, plus the presence of a trend – namely the general deterioration of small caps’ outperformance before 1990 into underperformance since then – lessens the likelihood that such an event occurs.

In short, the years since 1990 are likely to be prologue: small caps’ underperformance of mid- and large caps is more likely to be a normal than a temporary state of affairs.

Final Results: Monte Carlo Simulations

What, in practical terms, does the variability (standard deviations) of the returns in Table 3 – as well as the results in Figure 5 and Figure 6 – imply? Taking into consideration their fluctuations, are small caps more likely to underperform than to outperform mid-caps and large caps? To generate losses? What about the years before and since 1990? And what about small cap versus value and growth?

To answer these questions, I’ve conducted a series of simple Monte Carlo experiments (for background and details, see Want to Shrink Your Returns? Buy “Growth” Stocks! 23 March). Table 4 summarises one set of results. (For the sake of tractable presentation I’ve not disaggregated the probabilities of negative returns into pre-1990 and since 1990 components).

Table 4: Results of Monte Carlo Experiments (10,000 Simulated Observations), Small Caps versus Mid- and Large Caps, January 1926-December 2025 

These results corroborate the conventional wisdom; they also elaborate it.

Over ever longer intervals before 1990, small caps were increasingly likely – and over intervals of 40 years or more, virtually certain – to outperform both mid-caps and large caps. Since 1990, however, the relationship has reversed: small caps have been increasingly likely – and over intervals of 5 years or more, very likely – to underperform both mid-caps and large caps.

Table 5 summarises the other set of results (they don’t differ greatly before and after 1990; I’ve therefore not disaggregated them). They couldn’t be more fundamental – and they crush small cap speculators’ claims.

Over intervals of 20 years or more, small caps are likely to outperform “growth” stocks; but as the interval lengths, it becomes increasingly probable that value stocks significantly outperform small caps.

Table 5: Results of Monte Carlo Experiments, Small Caps versus Value and Growth Portfolios, January 1926-December 2025

If as a speculator (who’s interested only in short-term returns) you were forced to choose between small caps and growth you’d be indifferent between the two: the 12-month odds in Table 5 are a coin toss. That’s probably why advocates of small caps are mostly speculators. If, however, you’re a long-term investor, short-term returns are largely immaterial and medium- and long-term results are paramount.

On that basis, you’d put the odds in your favour. If you were forced to choose between small caps and growth, you’d select small caps. But if you could choose freely, you’d avoid “growth” like the plague; you’d also weight heavily towards value and away from small caps.

Why Do Small Caps Now Underperform?

Why since approximately 1990 have small caps ceased to outperform large caps? Investigators have nominated four key reasons (for an overview, see “What happened to the U.S. small-cap premium?” Vanguard Australia, 28 September 2025).

#1: Small-Caps’ Deteriorating Quality

Unprofitable comprise companies comprise a growing and now substantial portion of small-cap indices. Approximately 40% of the members of the Russell 2000 reported negative 12-month earnings in Q3-25. That’s among the highest percentages on record. It’s more than doubled since 2007, and shows a clear upward trend (see, for example, Torsten Slok, “The Share of Companies with Negative Earnings,” 30 September 2024).

#2: The Dominance of “Mega-Cap Techs”

Over recent decades, American markets have been dominated by a few massive and highly-profitable companies such as Apple, Alphabet, Microsoft and Nvidia (see, however, Intangible assets aren’t as valuable as bulls assume, 12 December 2025). Mega-caps benefit from scale and network effects far more than small caps.

#3: Markets’ Structural Shifts

Also over recent decades, promising companies have increasingly been funded by private equity and venture capital; as a result, they’re remaining private longer. When they list on a public exchange, they can do so as mid-caps and even large caps. Airbnb, Facebook (now Meta) and Uber are prominent examples.

4: Index Construction and Passive Inflows

As a final point, and given point #2, massive inflows of capital into index funds – particularly ETFs – have favoured the largest companies, and thereby further lifted their valuation premiums relative to small caps. As a result, the “size premium” has increasingly favoured large caps and penalised small caps.

Leithner & Company’s Attitude towards Small Cap Stocks

Words such as “cautious” and “sceptical,” and the phrase “value trumps size,” encapsulate our attitude towards small caps. Our analysis underpins it: it elaborates as well as corroborates the mainstream.

Most importantly, over longer terms value stocks thrash small caps. Accordingly, we’re very sceptical – as the consensus of finance academics has become – about the so-called “small cap premium.”

We mustn’t, however, overstate our results. Although we eschew “tech” stocks (see in particular Why we’ve never held tech – and have long owned energy, 2 March) and shun “growth” stocks (Want to shrink your returns? Buy “Growth” Stocks! 23 March), we don’t automatically reject a company from consideration as an investment simply because its market cap is less than $2 billion.

In principle, we’re happy to hold a few small caps when they offer exceptional value. That’s what I mean by “value trumps size.”

Today, our top-five holdings are mostly large caps (they were mid-caps when we acquired them), but the next five include at least one small cap (whose market cap is ca. $1.7 billion). We reject any whose histories are short or erratic, and are burdened with high debt or weak operating cashflows; in other words, on this basis we reject virtually all small caps. Instead, we demand established businesses with strong market positions and finances. Crucially, these attributes are much more characteristic of mid- and large caps than of small caps.

That’s why, since our formation in 1999, our portfolio’s focus has shifted toward well-established, well-financed and undervalued producers of essential goods and services. It’s been a tacit rather than a conscious and deliberate evolution towards mid-caps and large caps.

Implications: Intelligent Investors Avoid Small Caps

More than 90 years ago, Benjamin Graham advised that conservative investors acquire well-established, industry-leading and strongly-financed companies selling essential goods and services when the prices of their shares sink well below prudent assessments of their values. Such companies, unlike small upstarts, are much better able to overcome economic, financial and other vicissitudes.

In this respect, as in many others, Graham’s thinking permeates Leithner & Company’s operations.

In the 1940 edition of Security Analysis, he wrote: “bonds of smaller industrial companies are not well qualified for consideration as fixed-value investments.” “The bonds of very small enterprises,” he elaborated, “are subject to objections which disqualify them as media for conservative investment. A company of relatively minor size is more vulnerable than others to unexpected happenings, and it is likely to be handicapped by the lack of strong banking connections or of technical resources.”

These drawbacks apply equally to small companies’ stocks.

“The main drawback of a typical smaller sized company,” he noted, “is its vulnerability to a sudden and perhaps permanent loss of its earning power. Undoubtedly such adverse developments occur in a larger proportion of cases in this group than among the larger enterprises. As an offset to this we have the fact that the successful small company can multiply its value far more impressively than those which are already of enormous size.”

Ultimately, however, in Graham’s view small caps’ actual risks outweigh their potential rewards.

In The Intelligent Investor (1949), he wrote: “if we assume that it is the habit of the market to overvalue common stocks which have been showing excellent growth or are glamorous for some other reason, it is logical to expect that it will undervalue – relatively, at least – companies that are out of favour because of unsatisfactory developments of a temporary nature.”

“This,” according to Graham, “may be set down as a fundamental law of the stock market, and it suggests an investment approach that should prove both conservative and promising.”

“The key requirement,” he continued, “is that the enterprising investor (must) concentrate on the larger companies that are going through a period of unpopularity. While small companies may also be undervalued for similar reasons, and in many cases may later increase their earnings and share price, they entail the risk of a definitive loss of profitability and also of protracted neglect by the market in spite of better earnings.”

Graham concluded: “the large companies thus have a double advantage over the (small ones). First, they have the resources in capital and brain power to carry them through adversity … Second, the market is likely to respond with reasonable speed to any improvement shown.”

That’s why intelligent investors, as Graham defined them, avoid small caps.

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