It used to be simple: small companies went public, grew, and investors participated along the way. Today, companies stay private longer, and private markets have claimed many opportunities that once lived in public stocks. Historically a source of some of the strongest market returns, small caps have shred that reputation. The question becomes: Where did the small caps go?
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Danny Noonan:
It used to be simple, small companies went public, grew into big ones, and investors were able to participate in that journey along the way. But somewhere along the line that story changed. Companies are staying private longer, and venture capital and private equity have eaten away at many of the opportunities that once lived in public markets. Small caps and asset class long associated with delivering some of the strongest stock market returns through the decades leading up to the 1990s, earned them the term small cap premium, but they have since lost ground. So the question becomes, where did the small caps go?
Welcome to Simple but Not Easy, a podcast from Morningstar's Wealth Group. I'm Danny Noonan, senior investment writer for Morningstar Wealth, and I'm delighted to be joined by a great guest today, Morningstar, Zach Evens, who will help us unpack all of this.
This is a new season of the show I'm taking over for Nick VanDerSchie, who has a full plate actually managing the Morningstar Wealth business. So the podcast fell into the hands of someone less important. That would be me.
With that, let's get started. Zach, welcome to Simple but Not Easy. Thanks for joining us.
Zach Evens:
Thanks for having me.
Danny Noonan:
Before we dive in, why don't you tell us a little bit about your role here at Morningstar?
Zach Evens:
Sure. So I am a manager research analyst on the Passive Strategies Team, and what that means is I evaluate or write about, I talk about passive strategies and because of the origins of exchange traded funds, ETFs, a lot of my coverage revolves around ETFs and I kind of covered that marketplace in particular doing a lot of research and commentary on ETFs.
Danny Noonan:
Awesome. You put together some great work recently, and one of the reasons we're excited to have you on it was a paper called How Private Companies Are Reshaping Public Markets. I'd seen it. It's doing a lot of work outside of Morningstar. I saw it on one of my Sunday morning newsletters, med Faber, the Idea Farm. It got published there. A financial advisor I follow closely, Lawrence Hamtil. He was posting a lot of the charts that you had in the paper as well, so getting a lot of traction. And so just seeing in all those places, that's one of the reasons. Great topic we're excited to have you on, but at a high level, what sparked the topic?
Zach Evens:
Sure. One of the first charts in the paper was a relative growth chart of the Morningstar US small cap index relative to the Morningstar US large cap index. It showed this waves of out and underperformance. It started in late 1991 or early 1992, and the small cap index outperformed, then it underperformed the net outperformed. And then over the last 15 or so years, it has pretty severely underperformed the large cap index. I think over the last 10 years. The small cap index has underperformed the large cap index by I think 6.7 percentage points annualized, which is pretty significant. And since a lot of my coverage on the manager research team includes small cap index funds, I wanted some answers for a why they underperformed large cap index funds, the worst large cap index funds, so severely and B, if that underperformance might continue into the future.
Danny Noonan:
So we've obviously seen an incredible expansion in private markets in recent decades. Apollo, CEO, one of the leading private market companies actually spoke at the Morningstar investment conference in June. A great stat I've seen from them is that almost 90% of firms with revenue greater than a hundred million in the US are actually private companies. I don't think most people realize that, that a big portion of the economy sits outside of public markets. How has that shifted over time? What's driving that?
Zach Evens:
Yeah, so first I want to unpack that quote a little bit. I think it's a very interesting quote. I was in the room with Mark Rowan when he was speaking at the conference and the quote, you said 90% of firms with revenue greater than a hundred million in the US are private. But I would kind of push back on that and say how many of those firms are actually investible? Is it the full 90%? I would argue probably not. It's probably a lot less than 90%. I don't know the number I wish I did, but I would imagine it's a bit less than 90%. So I think there is this kind of a notion that most of the US economy is outside of public markets, and I think that is generally true, but how much of that economy is actually investible? And as we're talking about this public private convergence, can we actually get to what is the high watermark for investability of those private assets?
Danny Noonan:
So you're telling me the HVAC company down the street, I can't just go invest in them if I want to.
Zach Evens:
No, probably not. The taco join, not the local dentists, things like that. Even these large companies which have over a hundred million dollars in revenue, a lot of them are family owned and operated, owner owned and operated, and probably not investible for a host of different reasons. Okay,
Danny Noonan:
Great. Pushing further in that direction. On top of that, there's been some recent regulatory changes that make private markets more accessible to a wider group of investors. Is that a catalyst to speed up the shift towards more private market investing?
Zach Evens:
Yes. Yes. It could be a shift, although I think that shift could take time while the regulations might change. Trump's executive order on August 7th opened up 401ks to private assets. While the regulations might shift, asset managers and investors kind of need to meet the regulation shift. Asset managers need to provide good products to invest in those private assets. The private companies have to be willing to sell their shares to those products so investors can invest in them, and investors need to want those private assets and those private funds. And if the funds and the products are not compelling, investors might not necessarily allocate to those products in the first place. Or if they do, they might quickly sell out if they realize high risk or underperformance or any of those drawbacks that might come with private market investing.
Danny Noonan:
I think one of the simple truths about investing is that asset classes are always competing with each other for investor capital. Money likes to go where it's often treated best as private markets grow their influence. I think the part of the public markets that seems most affected, and this a big part of your paper is small caps. Can you shed a little bit of light on that?
Zach Evens:
Sure. So I think small caps are most vulnerable to this shift for a number of reasons. And in the paper I outlined three ways in which private markets are impacting small cap stocks. I kind of frame it as broadly public markets, but I think small caps are most susceptible for a few reasons that we'll get into. So the first is that high potential firms are staying private for longer or not IPOing at all, and if they do ipo, they're IPOing into large cap territory. So if you think about the most promising highest growth potential, most exciting private market companies, private companies are the opening eyes, the SpaceXs, philanthropics X, all these companies that you see in the news, they are not public companies, and if they were to be public, they would almost instantly be some of the biggest holdings in the s and p 500 or other large cap focused market cap weighted indexes.
And the second way in which private markets are impacting public markets is that cash rich private firms as funding swells for private equity and venture capital, that cash needs to be deployed. And there's an interesting difference to generalize, I won't say this is always the case, but to generalize, private investors might want growth at all costs, expanding revenues, expanding sales, just capture market share at whatever cost. Whereas public market investors, especially at the smaller end where they might have weaker competitive advantages, narrower margins, they want a profits, just profits and then be sturdy margins. So there's kind of a little bit of a difference in the objectives of public and private investors. And what that means in these industries that public companies compete in and also private companies is that private companies are competing fiercely with public companies. And because small cap public companies have weaker or fewer competitive advantages than larger companies, they're more susceptible to that increasing competition. And in one area in particular that we're seeing, this is in biotechnology and some active fund managers are observing this and just staying away altogether, not taking any active exposure in that sector.
Danny Noonan:
Yeah, if we could pivot conversation, I think it'd be good area to explore would just be the focus on public small cap investing. You alluded to it just there with the weaker competitive advantages, but historically it's been true that small caps come with more risk than large caps other than competitive advantages. I mean, what else would you cite to kind of unpack that one?
Zach Evens:
Sure. Well, so they're smaller. They're smaller than larger companies. Bigger is not always better. However, more
Danny Noonan:
Cyclical too, I imagine.
Zach Evens:
Yep. More cyclical. So they have smaller balance sheets, smaller income statements, just kind of less financials to support their businesses. But I also think the fewer and weaker competitive advantages is an important point too. So if you think about some of the biggest stocks in the market, Microsoft City, Amazon's the magnificent seven, or the FANG or whatever acronym you want to use to describe some of the biggest stocks in the market, those are also some of the best and highest quality stocks in the market. By and large, high quality stocks are less frequently observed in a small cap index than in a large cap index. And to take that to a Morningstar moat rating, most of the companies with the highest moat rating are in that large cap index rather than in that small cap index.
Danny Noonan:
I think the caveat to the additional risk would be that it has historically been rewarded through higher returns for small cap investors, but that hasn't been true recently. As you point out in the paper from 1992 through August of this year, that's more than 30 years. Small caps have trailed large caps by more than 400%. Only one reasonable question to ask based on that stat, would Gene Fama try and fight you if you shared that stat with him?
Zach Evens:
I would hope not, but I would hope that he would look into that underperformance and want to ask some of the same questions that I'm asking in the paper.
Danny Noonan:
And for those that don't know, gene Fama academic professor at University of Chicago, Nobel Prize Laureate, a lot of his academic research on investing filters into a lot of the ways that managed strategies are run these days, and he's kind of the grandfather of the small cap premium, the idea that small caps tend to outperform large caps over long periods of time. So just a little background on that. The more serious version of the question should be, investors have not been compensated for holding small cap stocks for roughly 30 years despite the risky tendencies. Why is that?
Zach Evens:
I think quality is an important point there. So a chart in the paper shows the quality gap between the small cap index and the large cap index, and as expected, it shows that over time aggregate quality is lower for small cap stocks than for large cap stocks. However, just in the last few years, in the last 10 years, and especially in the last five years, that quality gap has expanded rather significantly. So if you think about the complexion of the large cap segment of the market and the small cap segment of the market, and you think about the stocks that have performed exceptionally well recently, many of those stocks are large cap stocks. Maybe they started as smaller stocks, but most of them didn't necessarily start as very small stocks in the small cap index. They kind of grew from mid cap or grew from smaller large cap. If you think about Palantir as an example, or even stocks like Tesla or Apple or Amazon, they were large cap stocks and they grew their revenues, grew their profits, and kind of went from good or great businesses to great or excellent businesses, and outperformance followed.
Danny Noonan:
So it's not so much that small caps have gotten worse, it's the quality of the large caps is really separating the two. Am I getting that right?
Zach Evens:
Exactly. Yep. So in absolute terms, quality of the small cap index has actually increased ever so slightly over the last 20 ish years, but the quality of a large cap index driven by many of those large firms make a cap stock. Some of them in the technology sector has increased fairly substantially with their economies of scale.
Danny Noonan:
I think volatility is another avenue to explore. As you point out, the average drawdown of the small cap index has been roughly four percentage points deeper than large caps since 1991. Is that a function of the quality reduction or what other factors would be involved?
Zach Evens:
Yeah, I think quality is part of it. The finding in the paper is that the small cap index tends to be a little more sensitive, not just to market forces, but their fundamentals also tend to be more sensitive to economic forces. So another chart in the paper shows the volatility gap between the small and the large cap index, and it shows that the volatility gap as well as the quality gap tends to widen during periods of economic uncertainty or economic turmoil. For instance, during the 2008 financial crisis, 2008, 2009 and the 2020 COVID driven drawdown, the volatility gaps spiked along with the quality gap. And I think that reflects the relative sensitivity or even fragility of small cap stocks relative to large cap stocks, kind of for some of the same reasons that we were discussing earlier, just bigger revenues, bigger profits, better profit margins, better competitive advantages, large cap stocks are better suited to weather some of those economic storms. And I think that contributes to those deeper drawdowns,
Danny Noonan:
Right? So combine those two things, less quality, more volatility, and I think the fallout's obvious investors kind of lose their appetite for the asset class, so to speak.
We said at the beginning episode that money's always going where it's treated best, and that hasn't necessarily been small caps in recent history. You could look at valuations as one obvious data point to see how investors are reacting to the asset class. But more broadly, what do you think it would take to change the sentiment for small caps?
Zach Evens:
It's hard to say what will exactly change the sentiment for an asset class. A lot of things go into sentiment. Valuations are one of them, of course, but related to that is profit expectations, quality trends, market and economic trends, interest rates, a whole host of factors. So it could be any one of those that shifts the sentiment for a whole asset class. For example, earlier this year, European stocks for the first time in a while outperformed US stocks, and that was on the backs of shifting sentiment related to European defense spending and general economic optimism that they'll ramp up production and just generally grow their economy and thus grow their stock market. So that's kind of one area of the market that has seen a sentiment shift recently, but I don't want to speculate on kind of what that catalyst might be specifically for the small cap segment.
Danny Noonan:
Yeah, so the episode is about small caps. You just mentioned European stocks, which are having one of their best years in a while. Is there a contrarian element that runs through this place here at Morningstar?
Zach Evens:
I think there is. I think it goes back 40 plus years since we were founded.
Danny Noonan:
That's right. I just wanted to tease that out. There's another great chart in your piece. It shows the valuation spread between large caps and small caps. It's not quite at nineties tech bubble levels, but it certainly stands out when you look at it over the span of 30 years. Coincidentally, the nineties was a good time to own small caps. Could that be true this time?
Zach Evens:
So I think we need to consider first why the valuation gap is so big currently. And if you look at the chart, and if you look at the trends in the valuation gap, it hasn't been a spike recently. Whereas in the two thousands tech bubble, it was a spike as.com mania unfolded, large cap stocks were just bit up to the moon and what were they bid up on? There wasn't a whole lot backing them. There weren't robust competitive advantages. There weren't very strong fundamental metrics backing many of these companies. Whereas today, if you think about the best companies, whatever metrics you want to use to qualify a great company, many of those great companies are large cap stocks, and I think investors are paying up for these great companies, and especially as we're kind of experiencing economic uncertainty, it seems like every few years or honestly every few months, we go through these periods of, oh, what's going to happen next?
There's another drawdown. We're in a bubble. But investors just keep allocating to large cap stocks, and I think part of that is because they are relatively safer. They're really good companies built on great businesses with sturdy margins, high revenues, high profits, great competitive advantages. So I think that's partly why the valuation gap is so big. And then to tie that back to small caps, I think small caps outperformed following the dotcom bubble, partly because large caps underperformed and to look at small cap performance holistically. It's not that small caps have performed poorly, it's that large caps have performed great. And to be honest, I don't know if I see too many structural forces right now that might upset that or cause small caps to crash or cause small caps to race ahead of large caps. It's sort of seems to be somewhat status quo. However, one catalyst might be valuations. We talk about it all the time, how valuations are frothy by most metrics. Most people are saying that that valuations are frothy. So if they do revert somewhat to historical averages, then that could see greater opportunities for small cap investors.
Danny Noonan:
Based on your comments around large caps, I'm not getting the sense that you're predicting a recession anytime soon.
Zach Evens:
I'll leave that to our economic team.
Danny Noonan:
Good thinking. I think we should talk about the, arguably the biggest structural force that's reshaping small caps, the rise of private markets, venture capital and private equity are keeping high growth companies private for longer. How has that changed the opportunity set?
Zach Evens:
It's changed it in a few interesting ways, specifically looking at venture capital. I like to say it's sort of taken the juice out of small cap indexes in the small cap opportunity set. A common saying used to be or maybe still is that tomorrow's large companies are today's small companies. However, I might push back on that and say tomorrow's huge companies are already large or tomorrow's large companies don't currently exist or may not ever exist as a small cap public stock. So if you think about the upside potential for small cap indexes, the small cap opportunity set, investors need to consider the complexion of that small cap market and the types of stocks that exist in that market and their upside potential. And I think that venture capital is allocating funds to the best and most profitable or the highest growth potential. Maybe not profitable currently, but hopefully in the future companies. So they're kind of taking out or not allowing some of that growth potential to accrue to small cap public market investors.
Danny Noonan:
I think there's this narrative out there that everything is staying private. A company like Stripe would be an interesting example. They're one of the largest private companies founded all the way back in 2010, and they've mentioned recently that they may stay private forever, but your research shows IPO activity is still happening. It's just a bit different than it used to be. What's the story there? How have IPO dynamics been shifting?
Zach Evens:
Sure. So, I think there is the common narrative that the IPO market is dead, or the only IPOs that are happening are large. I think that's false. The data shows that it's false. Using PitchBook data, we see that over 150 companies have IPO in the last few years, and 2021 was a record year for IPOs. So IPOs are still happening. Companies are still seeking exits through public markets, and many of those IPOs are firmly in small or even cap territory shown by the median post valuation was the metric used in the paper to show that. However, to bring that to the prior point of venture capital allocating to the most promising private companies, I think there's a point to be made that some of the most promising private companies are not going public currently. You mentioned Stripe, OpenAI is now a $500 billion company, has not gone public. SpaceX, same thing. Some of these companies that have a hundred or 500 Xed in private markets have done that in private markets and not public markets. So, I would be curious to see how many stocks have actually enjoyed that same sort of growth in public markets after IPOing into small cap territory.
Danny Noonan:
Yeah, so it sounds like the best private companies, the biggest brands we all know, you mentioned a few there, those are probably the highest quality in private markets, at least the way I perceive it, and they're saying private longer. So, the stuff that's coming public, is it junkier or less quality?
Zach Evens:
I think maybe there's just a little less interest in them. There could be less interest from venture capital. There could be less interest from other private investors and also maybe the founders. Maybe the owners want an exit, maybe the employees want an exit. There's a limit to kind of what you can do in private markets, how many shareholders you can have in private markets. So at some point the book swells so much where you have to exit or kind of some ways around that. But if you're an owner, if you're a founder and you want liquidity, if you want to realize some of those paper gains that you've worked so hard to get, public markets are still an appealing avenue for some firms.
Danny Noonan:
Okay. Yeah, that makes sense. I guess in terms of the shifting dynamics between public and private and small cap space, if I'm an active small cap manager, I run a mutual fund or something of the sort, how has this shift changed the way that I invest? Broadly speaking, are you seeing any interesting trends out there? I mean, are you playing owning companies with the hopes of that they get taken out? I mean, is that evolving into your thinking more now than it has in the past?
Zach Evens:
Sure. So I'll give credit for this section of the paper to our discretionary active equity manager research team who I consulted in talking about this very question and they observe two things, which I thought were very revealing. The first is that the competitive landscape is shifting in some of these industries. I think I touched on it a little bit earlier in that cash rich private firms are competing fiercely for market share with public firms, and because of the kind of differing objectives of public and private market investors, that's causing just a general kind of shifting competitive landscape in some of these industries and sectors. I mentioned biotechnology as an area where this is kind of acutely observed, but if you think about the companies that are most susceptible to that increasing business competition, it is small cap stocks, small cap public companies because they have smaller balance sheets, smaller income statements, weaker and fewer competitive advantages. So that's causing some active managers to expand their analyst research coverage of an industry or sector to the private market competitors and really focusing on holistically what is going on in a particular industry or sector, what will impact the future growth potential or the future downturn potential of their small cap public holdings.
Danny Noonan:
I think one of the things I should have mentioned in the last question is that there's a shrinking universe of investible small cap stocks. How is that filtered into decision making, just less opportunities in theory, if there's less stocks, does that create more demand for the stocks that are left in the small cap universe?
Zach Evens:
Sure. So I think this is actually a little bit of a misnomer too. There's been some research by Vanguard and others that shows that actually if you adjust the number of public companies for mergers and acquisitions, it has stayed roughly the same over the last few decades, which I think kind of refutes some of the common narrative out there that the investment universe is shrinking. It is true that the number of stocks is shrinking. However, if you adjust it for mergers and acquisitions, and a lot of those mergers and acquisitions are larger public companies, buying smaller public companies, it's actually stayed roughly the same. However, that still means that there are less investment opportunities for investors. So we're all picking from a smaller section of the whole market, and I think that's something that active managers have had to grapple with and kind of thinking about who's competing with them, what types of stocks they're picking.
Danny Noonan:
Right. Okay. The last thing I wanted to talk about in the private markets, obviously we touched on the regulatory changes at the beginning. We referenced Apollo earlier in the episode. It seems like a lot of the private markets they want to provide access to investors through 401k plans. What type of timing do you sense around that? Is this something we're going to see in 2026, or is it much longer than that? It'll
Zach Evens:
Probably take a little bit of time. So while the regulations might've changed, there might be efforts out there from asset managers and others to get more private assets in the hands of more investors. I think it will take some time for a investors to get comfortable owning private assets and B, asset managers figuring out how to give that access and compelling access to investors. There's kind of a supply and demand push. Asset managers certainly want to offer private assets to more investors for a lot of different reasons. The cynical reason is they can charge higher fees for private market vehicles than maybe an index fund that charges mere basis points. But yeah, so I think the demand side also plays into that where investors need to want the funds that the asset managers are offering, the asset managers need to offer great and compelling funds that perform well, that do exactly what they say they will, and if they don't, investors won't allocate. Or if they do, they'll pull their money quickly. So I think to see staying power, we'll have to see really good quality and investments with long-term merit on the private asset side.
Danny Noonan:
Okay. I'm not holding my breath for any private market options in the Morningstar 401k starting next year. Then before we wrap up, I wanted to take a step back and just kind of summarize what all this might mean for investors. As we think about small caps in this evolving landscape, private markets are growing. What's your best thinking for investors that are trying to navigate this space today?
Zach Evens:
Yeah, so I don't think small cap investing is dead. As we mentioned at the outset, small cap outperformance comes in waves. There are a lot of factors that contribute to how an asset class performs, including small caps and interest rates as part of them economic and macro factors is another, not just private markets. So the purpose of this paper was really to kind of shed a light on the impact that private markets are having on public markets and specifically the small cap opportunity set. However, I think the paper and the research shows that they are having an impact and that impact is most felt right now on the small cap segment. So I think what that means for investors is that they should be deliberate in what types of stock they pick. They should be deliberate in what type of funds they pick, and we're also seeing that on the active management side as well. So active fund managers in this segment are generally referring higher quality small cap stocks, ones with decent competitive advantages, ones with decent balance sheets and income statements, not necessarily the speculative names. With no competitive advantage that might be most susceptible to the increasing business competition from private firms. So I think it just requires an extra level of care. I think there can still be success in small cap investing, just I think investors need to think carefully about it as they go about investing.
Danny Noonan:
Great insight. Beyond the investment community, I think 2025 was a year that private markets really burst into the mainstream OpenAI being the most obvious example of 700 million weekly users. Now, it seemed like a week didn't go by in the last few months where a new large fundraising round was announced on the front page of the paper. What do you see for next year? Can private markets outdo themselves?
Zach Evens:
I don't think you should bet against 'em, and I'll leave it there.
Danny Noonan:
Okay, fair enough. Looking ahead to the rest of your, what's got you most excited either personally or professionally?
Zach Evens:
So I'm a big Seattle sports fan. Ah, I was rooting for your Mariners. That's too bad. I was too. I was too. So unfortunately I don't have the World Series to look forward to, but the Seahawks looked pretty good, so Im excited to watch them this season and hopefully compete for an N FFC West title. Awesome.
Danny Noonan:
Yeah, I mean the Bears started oh two. No, they won four in a row for the first time in what seems like a decade. So
Zach Evens:
Are you a Bears fan?
Danny Noonan:
I am. I would say unfortunately previously, but once we won four in a row, now I'm feeling good about 'em.
Zach Evens:
Don't look too bad.
Danny Noonan:
Yeah, Halloween next week. You dressed up as anything.
Zach Evens:
Maybe I should dress up as Gene Fama apparently, get back in his good graces
Danny Noonan:
Gene's doing fine. I saw him at a conference a couple of years ago. He is living in Santa Monica, and I think he plays golf every day.
Zach Evens:
That's the life
Danny Noonan:
He's not hurting. We'll link to the research paper that we talked about in the show notes, but for anyone interested in what you and the team are working on anywhere, we should send them.
Zach Evens:
Morningstar.com. You can find all of our research on morningstar.com.
Danny Noonan:
Awesome. Zach, thanks for joining. Simple but not easy.
Zach Evens:
Thanks, Danny. Have fun.
Danny Noonan:
And there you have it, another episode of Simple but Not Easy. As always, we thank our guests for their time and engagement Before we depart. If you enjoy hearing the insights on our podcast, please consider leaving a five star review on Apple Podcast or Spotify. Until next time, thanks for listening.
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