Tilting Away from Large Stocks

By Cannon Carr

Chief Investment Officer

October 16th, 2019

At the end of Q3, our research indicated a strong signal to tilt portfolios away from Large stocks and toward Mid and Small stocks within the US region.

For context, recall that we have calibrated our investment models to give a signal when meaningful imbalances are likely to have occurred across three principle areas: market size (large stocks or small stocks), investment styles (value, growth, momentum, quality, etc.), and global regions (US and international).

This recent signal derives from our test for market size. It is based on the mix of Large, Mid and Small stocks that comprise our “Best Ideas,” where at this point Mid and Small stocks make up a bigger than usual proportion, according to our multi-factor fundamental models. Whenever Large, Mid-sized or Small stocks make up a bigger than usual share of this group, our research indicates, they may offer the best return potential.

This makes some sense when you consider that in the US market, Large stocks (as measured by the S&P 500 index) were up 5.6% over the past year (ending 9/6/19) while Small stocks (measured by the S&P 600 index) were down -12.9% -- a meaningful difference of 18.5%. Our research has shown that winners in the US market did not win forever, and laggards did not lag forever; in contrast, we found that the odds were more likely that the current laggards and winners would reverse their relative pattern once an extreme point like this one occurs.

For context, these patterns tended to occur over longer periods—at times as short as six months, but more typically 12-18 months – or even several years. As we’ve noted before, we believe we can tell WHERE these extremes occur, but it is essentially impossible to tell WHEN they actually shift. It takes patience to see it play out.

For portfolios, this action means that we sell ETFs that hold Large stocks and allocate the proceeds to what we think is one of the next-best opportunities—in this case, ETFs that hold Mid and Small stocks, split equally between the Core and Value styles¹. We also retain a meaningful allocation to Mid-sized stocks (also split between Core and Value), which became more attractive earlier this year in May. Mid-sized stocks offer some of the most attractive return potential at this point, in our view.

As a MAP investor, you may be wondering whether this tilt changes your portfolio’s customized risk profile and goals. The overarching answer is, no—primarily because we have not changed the overall investment objectives reflected in the allocation to Appreciation (offensive investments like stocks) and Defense (defensive investments like fixed income). The portfolio is diversified to help keep risk/reward in balance, and the offensive playbook contains more than just Large US stocks, but international components, real estate investments, etc., alongside the defensive allocations.

Still, within the “offense” category, we have incrementally moved toward a historically more volatile group in Small stocks, which could add incremental risk. The purpose here is to position the portfolio for improved incremental returns (by tilting from Large to Mid and Small within the offensive playbook) at a time that Small stocks have already lagged. On balance, we believe the risk-reward is in investors’ favor when Mid and Small have statistically high weights within the “Best Ideas” of our fundamental model. We believe it is the right strategy for long-term, patient investors.

Bottom Line: After a period of meaningfully divergent returns, our research has signaled a significant extreme in the risk/reward opportunity between Large, Mid and Small stocks in the US. The role of Large stocks in the Appreciation/Offense allocation is accordingly less attractive at this point; we have sold the ETFs that represent this market cap and increased our allocation to Mid and Small stocks for what we believe will improve the return potential of the portfolio while maintaining an acceptable balance of risk in the overall, diversified portfolio.

Past performance is no guarantee of future performance, and CornerCap’s strategies, like most investment strategies, involve the risk of loss. You should not assume that future performance results will be profitable or equal to CornerCap’s past performance.

¹ Our models have tilted toward the Value style since last October-November. We include a Core allocation (which is essentially style-neutral) in more volatile stock groups like Small and Mid-sized stocks for diversification.