Why Not Just Own Large Caps? | Bragg Financial (2024)

If you have reviewed your recent performance report or read Matt DeVries’s 1st Quarter 2024 Commentary, you may have noticed that US Large Cap outperformed US Mid Cap and US Small Cap yet again. Large cap, as represented by the S&P 500, has come in first in this performance derby six times in the last eight calendar years. Mid cap led the way only once, and the same is true for small cap. When you look at the column showing ten-year returns in the chart below, you may ask, “Why would I want to own anything other than US Large Cap?”

One of our clients recently posed that question, though he phrased it, “Why do you keep buying the underperforming portions of the market?” Other ways of asking that question are, “Why don’t we chase after what has been hot?” or “Shouldn’t we just load up on recent winners?” Hopefully when phrased like that, it sounds far less appealing. These queries might seem logical at first glance. However, this perspective overlooks a fundamental principle of investing: diversification.

Taken to extremes, one could point to the single-best-performing security in your portfolio over the last five years and insist that we load up on this big winner. As we look at our Bragg Financial portfolio, that would be Applied Materials. Should we put all our money into Applied Materials? We may like the company as an investment but think this would be a bad idea.

With hindsight, we can say that we wish we had invested everything in large caps over the last ten years, but that doesn’t mean we’re going to do it now. All market cycles come to an end at some point; then there is regression to the mean. Depending on the time, an asset class–like foreign stocks or small caps–or a sector–like real estate, financials, or healthcare–may emerge as the new leader, providing above-average returns while the leaders of yesterday provide below-average returns. Basic diversification is important; only with hindsight can we identify the best investment for the most recent period.

We all suffer from recency bias, which is the tendency to place too much emphasis on our most recent experiences. We anticipate that past events will keep happening in the future. Looking beyond the last ten years, you will see that small- and mid-cap stocks have outperformed large-cap stocks over the past 25 years. That is remarkable considering the recent decade of smaller company underperformance.

Seeing the chart above, it should not come as a surprise that small caps must have performed very well earlier this century. Indeed, they did, as shown in the table below.

Large caps did very well in the late 1990s but began a long period of underperformance when the Dot-Com bubble burst.

This has also been a rough eleven years (2013 to 2023) for international equity compared to US Large Cap. But the previous eleven years told a much different story, with international equity significantly outpacing the S&P 500.

Another reason we wouldn’t want to own only large caps is valuation. The price-to-earnings (P/E) ratio, a key metric for stock valuation, currently suggests that large caps are significantly overvalued compared to their mid-cap, small-cap, and international counterparts.

The P/E ratio for large caps is 34.2% above its 20-year average, while mid-cap, small-cap and international stocks show much smaller deviations from their historical averages (Source: JP Morgan Guide to the Markets, 03/31/2024). All other things being equal, this measure indicates that large caps are overvalued relative to mid-cap, small-cap, and international equities.

Conclusion along with a defense of large cap:

We are proponents of large-cap investing. Since I joined Bragg Financial in 2012, we have consistently aimed for two-thirds of our equity holdings to be in large-cap companies. Because of their size, large-cap companies tend to be well-established businesses with solid balance sheets, making them less risky individually than small-cap stocks. However, the market is broader than just these biggest companies, and now is likely not the best time to increase our allocation to them.

In recent years, large cap stocks have led the way with strong returns, but investors should not overlook the importance of a well-diversified portfolio. No single asset class, sector, style, or stock can maintain dominance indefinitely. Allocating across various asset classes not only lowers portfolio volatility, but also enables you to benefit from exposure to the best-performing asset classes, as specific leaders will rotate in and out of favor over time.

This information is believed to be accurate at the time of publication but should not be used as specific investment or tax advice as opinions and legislation are subject to change. You should always consult your tax professional or other advisors before acting on the ideas presented here.