How Big is Big? Part II

Yesterday in this space we talked about framing and understanding how big big really is. (See our commentary "How Big is Big?") Today we've got another perspective on the same topic.

The tradeoff in performance between the so-called "big cap" and "small cap" stocks is an important style decision portfolio managers have to make. Since the most recent bull market's inception, small caps have beaten the pants off big caps. Traditionally, small caps tend to outperform in the first half of a bull market and big caps begin outperforming as the bull becomes more mature.

Never mind that many economists have been calling for big caps to regain primacy for a couple years now. All this exalted wisdom is useless unless you actually know what big and small are in the first place.

Boeing. Motorola. Yahoo! Viacom…these companies are industry bellwethers and make headlines in the financial press regularly. But from the market's perspective they're not the juggernauts we perceive them to be. They're all small.

Of global stocks in the developed world as measured by the MSCI World Index, the weighted average market cap of all companies is $76 billion. So on a cap-weighted basis, anything below $76 billion is smaller than the market, and anything above is bigger.

Boeing's market cap: $70 billion.
Motorola's market cap: $50 billion.
Yahoo's market cap: $37 billion.
Viacom's market cap: $26 billion.

They're all small!

This isn't just a statistical trick. Stocks that are smaller than the market on a cap-weighted basis tend to behave like small stocks. Most of the time people think of small caps as tiny, illiquid little securities that only analysts and traders know about. But names you hear everyday in the financial press are small. Almost all public companies are small.

Exxon is a BIG stock at about $450 billion in cap. General Electric is big ($240 billion). So is Bank of America ($240 billion). Only a handful of companies are actually larger than the weighted average cap of the market, yet they comprise more than 80% of the total cap in the index! The vast majority of stocks, thousands, are below the average and therefore "small."

You can't make a proper style assessment of small versus big if you've made the cognitive error of framing cap sizes in the wrong way in the first place.

We don't know when the change will occur and big caps start outperforming. But we don't think it's likely to happen immediately. Trends tend to last a lot longer than most people realize and with many experts expecting big to outperform right now, such an outcome is probably priced in. We likely need to see real capitulation in the market with headlines like "Small Caps Are for All Time" first. Also, in the midst of current record M&A activity, smaller companies are the ones having their stocks bid up because they're the ones getting bought. As long as M&A is strong, small stocks should continue to do well (See our past commentary, "Age of the Conglomerates," "Privatizing profits," and "Not All Destruction is Created Equal" for more). And we see no end to big M&A activity in sight for 2007.