Why have large caps outperformed small caps?

If we look at the return of the XFL (S&P/ASX 50) from 2 Jan 2023 to 11 June 2024 we can see the index returned 10.75%. If we compared the XSO (S&P/ASX Small Ords) with the same dates we only have a return of 6.85%.  We discuss the various factors which have contributed to the outperformance of large-cap stocks compared to small-cap stocks below:

Stability and Resilience: Large-cap companies are often more stable and resilient during periods of economic uncertainty or market volatility. They typically have diversified revenue streams, global operations, and strong balance sheets, which can help them weather economic downturns more effectively than smaller companies.

Dividend Payments: Large-cap companies are more likely to pay dividends compared to small-cap companies. Investors seeking income or stability during turbulent market conditions may favour large-cap stocks with reliable dividend payments, which can provide support for their stock prices.

Interest Rates and Inflation Expectations: Small caps can be particularly sensitive to changes in interest rates and inflation expectations. In environments where interest rates are rising or inflation expectations are high, small caps may struggle as their borrowing costs increase and their profit margins are squeezed.

Access to Capital: Smaller companies may face challenges in accessing capital compared to larger companies, particularly during periods of economic uncertainty or market volatility. Limited access to capital can hinder small caps’ ability to invest in growth opportunities and compete with larger rivals.

Liquidity Concerns: Smaller companies typically have lower trading volumes and less liquidity compared to larger companies. During periods of market stress, investors may prioritize liquidity and flock to larger, more liquid assets, leading to underperformance of small caps.

Tech Dominance: In recent years, the dominance of technology stocks, particularly among larger companies in the US, has contributed to the underperformance of small caps. Investors have favoured companies with strong growth prospects and technological innovation, which are often found in larger companies, at the expense of smaller, more traditional businesses.

Global Trade Concerns: Small caps are often more domestically focused than larger multinational companies. Concerns about global trade tensions or geopolitical instability can weigh heavily on smaller companies that rely heavily on domestic markets for revenue

These factors, combined with the overall strength and resilience of large-cap companies, contribute to their outperformance relative to small-cap stocks in many market environments. However, it’s important to note that market conditions can change over time, and small-cap stocks have historically demonstrated the potential for strong performance, particularly during periods of economic expansion and market optimism.

Lauren Hua is a private client adviser at Fairmont Equities.

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