Conventional wisdom has long held that investing in small-capitalization stocks has the potential to reward investors with excess returns relative to larger stocks. Generally speaking, the historical record supports this, as small caps have materially outperformed large caps over most extended market periods. However, structural changes have emerged in the small-cap universe that imply the returns of the past might not extend to the future unless investors alter investment approaches.
The small-cap universe has traditionally been fertile ground from which relatively young, promising companies can raise capital. The public markets typically have offered depth, liquidity and valuations at a considerable premium not easily found in the private market. These benefits have outweighed the demands placed on public companies: reporting requirements, quarterly scrutiny and often steady pressure from investors to meet growth and profitability targets.
Over the past decade, regulatory changes and a significant expansion of private equity funding has altered the cost/benefit profile of public equity. This has resulted in fewer small companies going public. As companies remain private longer, the small-cap universe suffers a decline in the replenishment cycle.