One of my favorite writers is Jason Zweig, author of The Wall Street Journal column, “The Intelligent Investor.”

Zweig recently suggested that it might be time to consider the merits of small-cap stocks. I added a modest exposure to small-cap stocks to my portfolio a few months ago so I thought it would be worthwhile to discuss this idea.

Let’s first put some definitions in place.

“Small-cap” stocks are defined as stocks of public companies with a market capitalization typically ranging from $250 million to $2 billion — so they aren’t really all that small.

They are often associated with younger companies that are in a growth phase, and can be found across a wide range of sectors including finance, health care, technology, retail and more.

Some names you might know include Carvana, Dillard’s, Fluor, Papa John’s, Redfin, Sprouts Farmers Markets and Super Micro Computer. The small-cap market is represented in the Russell 2000 Index, which includes companies ranked from No. 1,000 to No. 3,000 in size.

So, why think small when big has been where all the action has been?

Looking in the rear-view mirror clearly shows that the Russell 2000 has considerably underperformed the S&P 500 (home of the largest 500 companies):

Annualized Total Returns

A deeper dive may provide an even better look. Much of the Russell 2000’s underperformance comes from underexposure to tech stocks.

Technology stocks account for nearly a third of the S&P 500’s total capitalization, compared to less than 13% of the Russell 2000.

Note that just seven stocks within the S&P 500 — referred to as “the Magnificent Seven”: Nvidia, Tesla, Amazon, Microsoft, Meta, Apple and Alphabet — grew 697% over the past 10 years, while return for the overall S&P 500 was under 200%.

Many analysts believe that the S&P 500, especially when considering the seven tech stocks, is “priced for perfection,” arguing that massive artificial intelligence spending will in fact payoff as hoped.

Any disappointment could have a sizable negative impact on returns. Zweig noted that tech-dominated titans are trading at about 30 times net profits and nearly eight times net worth, while the Russell 2000 trades at about 18 times earnings and just two times net worth.

It’s also worth noting that the Russell 2000, while more volatile, has outperformed the S&P 500 in just under half the one-year periods over the past 40 years.

So, it might be worth considering the argument that asset-classes tend to come into and go out of favor over time. In other words, nothing tends to win forever.

Vanguard’s most recent 10-year forecast calls for U.S. large-cap stocks to return 4.7% versus 6.3% for U.S. small-cap stocks.

Schwab’s chief investment strategist, Liz Ann Sonders, suggested that not all small-caps are created equal with “zombie companies” within the Russell 2000 index. Instead, she recommended focusing on higher quality companies within the small-cap marketplace.

Quality factors include strong balance sheets, healthy growth prospects and consistent earnings improvements in trying to eliminate “zombie companies” that are heavily indebted with barely enough revenue to cover operating and interest expenses.

An example is Invesco’s S&P Small-Cap Quality EFT (XSHQ).

Another approach is with a value-oriented small-cap ETF like Vanguard’s Small Cap Value Index Fund (VSIAX) or BlackRock’s Morningstar Small Cap Value ETF (ISCV).  

Note that small-cap stocks represent about 8% of total market capitalization so neither Zweig nor I are suggesting a huge bet here.

But as investors have been chasing performance by pulling money out of small-cap stocks and pouring money into large-cap stocks, perhaps this might be a prudent time to include a market-weighted (5%-10%) allocation to small-cap stocks.