Leverage in Large Caps, Value in Small Caps

Value investing's performance has diverged sharply between large-cap and small-cap stocks in recent years. While value strategies have been effective in small caps, they have struggled in large caps. At the same time, investor attitudes toward debt differ: large-cap investors have benefited from highly leveraged companies, while small-cap investors have not.

This contrast is evident in charts tracking cumulative returns over the past three years for long-short, sector-neutral, monthly-rebalanced portfolios sorted by free cash flow (FCF) yield, Sales/Price, Earnings/Price, and Debt/Equity in the S&P 500 and Russell 2000. A bracket highlights the three value factors in each chart.

Why Is This Happening?

Small-cap companies typically carry more relative debt than large caps. As shown in the chart, FCF yield has delivered strong returns for Russell 2000 stocks—27% per year over the past three years and 32% in the last year. Small-cap investors likely prioritize FCF yield because it mitigates debt risk. Strong sales and earnings also reinforce financial stability. Highly leveraged small caps are less attractive.

Conversely, investors have been rewarded in large caps for favoring high debt-to-equity companies. This strategy has worked (so far) because large firms generally have stronger cash flows and financial stability, cushioning the risks of high leverage. Given this dynamic, it is unsurprising that FCF yield has not been a priority for large-cap investors.

In short, leverage and value investing have played distinct roles in large-cap and small-cap stocks.