The Small Cap Growth Lottery
Snapchat, Canada Goose, and Yeti made investors billions. The stories of their growth — and the savvy investors who bought in early — have dominated the front pages of the financial news.
These successful investments may inspire envy, but they should not inspire emulation. The vast majority of small-cap growth stocks underperform the market, while only a fraction score lottery-like outcomes.
Academics have observed this connection: Investors appear willing to accept poor returns on average in the hopes of hitting a big winner. Since gains are realized by a minority of stocks, the majority of small-cap growth stocks produce negative returns in aggregate.
Figure 1: Individual Stock Returns Over a Decade
Source: Bessembinder (2017)
The same phenomenon is even more pronounced in venture capital. The Kauffman Foundation published an article expressing similar dissent about the improbability of finding that “big winner” and reaping astronomical profits. Like the small-cap growth companies listed above, recognizable start-up successes like Facebook, LinkedIn, and Groupon have dominated positive returns in venture, but the broader venture market has underperformed.
To be specific, the Kauffman Foundation found that in the 20-year period before 2012 only 20% of venture funds outperformed the Russell 2000 by more than 3% annually, with half of these funds forming before the dotcom bubble. Figure 4 illustrates the skewness in the venture capital return distribution, one that mimics the skewness found in small-cap growth stock investing.
Figure 2: Public Market Equivalent (PME) Distribution Chart for Venture Funds
Source: Kauffman Foundation VC portfolio, 1989–2010. The Russell 2000 is the public benchmark.
Only 17% of these funds attained a Private Market Equivalent (PME) of 1.5 or higher, meaning they outperformed the market by 5% or more. After 1995, chances are slim that a venture fund could offer even slightly better returns than an index fund.
Based on these odds, small-cap growth investing could be considered more of a gamble than a prudent investment. So why are people so drawn to make risky decisions?
Behavioral finance research shows that the presence of greater uncertainty affects decision making. “Prospect theory,” developed by Daniel Kahneman and Amos Tversky, investigates how people think about prospects, gambles, and other decisions in situations where they feel uncertain. The theory suggests that individuals have a behavioral preference for gambles or lotteries when it comes to stocks that have the potential for a big payoff, even if the odds are poor.
Research by Barberis and Huang (1999) finds that investors can stomach small losses more readily if they previously made a huge gain. Barberis and Huang believe this shifts an investor's behavioral reference point. In essence, prior gains can “cushion” future losses.
The more stories there are about big winners among small-cap growth companies, the more investors are drawn to trying their luck in the hopes of achieving similar lottery-like returns. And past positive returns can increase risk tolerance, as investors discount small losses against previous big gains.
Investors should beware of dabbling in the small-cap growth lottery, a market designed to play on the worst behavioral biases of the investing public.