Historically, investors have been well-served by tilting their portfolios toward inexpensive stocks, which offer a low price relative to anticipated future cash flows. Small companies have also tended to outperform the broad market over time, as nascent firms (and industries) offer the prospect of high rates of growth. In order for these value and growth premiums to work, small and/or inexpensive stocks must be able to migrate out of their respective market categories. Successful value stocks became growth stocks, and successful small cap stocks became large cap stocks.
This logic has been flipped on its head over the past decade. Value and small cap stocks have lagged an increasingly concentrated set of high-priced and rapidly-growing companies, which have continued to gain market share in an environment of lax antitrust enforcement. The data-oriented business models of the so-called FANMAG group (Facebook, Apple, Netflix, Microsoft, Amazon, Google) are a key part of the story, but the trend toward increasing concentration of capital spans most industries. Matt Stoller has highlighted the extent and perniciousness of these trends in his blog BIG.
The business advantages of industry giants has seemingly justified high valuations and persistent stock market outperformance, to the detriment of market competition and dynamism. Meanwhile, the time-tested approaches of value and small cap investing are predicated on a level playing field, which allows out-of-favor and/or small companies to compete, grow, and eventually migrate out of their respective categories.
Capitalism does, and should, reward those who come up with better ways of doing business. The question that investors—and society at large—must ask themselves is: where is the dividing line between economies of scale and excessive market power, between innovation and predation? This is a nuanced conversation, but a vital one for the future of capitalism. To learn more, please read review our latest quarterly letter.
In the meantime, it’s worth observing that US value and small cap stocks are inexpensive by historical standards—even relative to the mania of 1999.