Good afternoon, everybody. This is Michael Cembalest with one of our July Eye on the Market webcasts. I know there's a lot going on this week, but for investors, there's something else happening that's important to keep track of, which is what's going on with small cap. And so we have a piece that we've been working on for a few weeks that's coming out this week called The Lion in Winter. I'll explain all about that.
Before I get into this small cap question, I just want to thank CrowdStrike for making the last 72 hours so interesting in terms of us trying to wrap this project up. I want to share a couple of quotes with you that I've got from FBI counterintelligence people and other people I spoke with who said, "CrowdStrike has done more to disrupt global business than all of the ransomware operators combined." That's obviously someone's personal opinion. And then another person referred to CrowdStrike having a severe failure of quality control.
What's interesting is that the CEO of CrowdStrike was the CTO, Chief Technology Officer, at McAfee in 2010 when these things can happen. Right? They published an update that mistakenly said that a legitimate Windows file was infected, and it paralyzed computers at hospitals and schools, and government agencies. And McAfee ended up losing 40% of its market cap that day. And they had to send 4,000 employees out to help clients recover.
I'm hoping that what comes out of this are some procedures where companies that are using these tools don't automatically absorb all the updates and test them first, and not just on the assumption that the company that did the update tested it. Also, it is interesting, when the government chided Microsoft last year for a cascade of security failures, CrowdStrike's CEO used that as an opportunity to bash Microsoft and say that there's a crisis of confidence among security and IT teams within the Microsoft security customer base. So we'll see what happens now.
OK. So here's this beautiful picture of a lion in winter. It's actually an amazing movie, if you haven't seen it, with Peter O'Toole. But lion and winter are used as a metaphor for small cap. I mean, most people don't think about small cap as a lion. But believe it or not, it used to be and was for 100 years.
We start out the piece with a chart showing that from 1930 to around 2010, small cap generally crushed large cap. This is looking at—we have a chart that looks at three-year rolling outperformance of small cap versus large cap. There were six distinct, long—meaning a decade or more—eras where small cap outperformed large cap. And so that's why this is the lion in winter, because it's been a long winter since small cap had this kind of outperformance. Certainly, on a sustained basis, it hasn't happened since before the financial crisis in 2009.
So we wanted to take a look at what's going on because small cap is now at its cheapest level in the 21st century. Now, to be clear, small cap is a—has trailed large cap, and so has non-U.S. stocks, and so value stocks. When you look at a chart on earnings growth over the last decade, large cap growth earnings have kind of crushed everything else, and with a remarkable lack of volatility. The amazing thing isn't so much that large cap growth earnings are higher than small cap and non-U.S., and value, and stuff like that. It's how resilient they've been during economic downturns.
And we have a chart in here that's kind of remarkable. You would not believe the earnings drawdown that took place in the Russell 2000 small cap universe compared to a very small one in large cap growth. So that's why people are paying those high multiples for large cap growth. But everything eventually has a price. Sometimes it's hard to anticipate how far the rubber band stretches.
After the soft June CPI report, we had the biggest one day reversal in 40 years for small cap, and defined as the one-day performance of small cap versus the Nasdaq. So on the day of the soft June CPI report, the Nasdaq underperformed small cap by almost 6%, which was by far the biggest number in 40 years. And then, if you look at the whole week, you get the same story.
So the purpose of this piece is, is this a trend or not? And so a table of contents—we try to cover a lot of ground here. Let's be clear about something. Small cap increasingly was not cheap just because people had a large cap growth fetish. There's a lot of data in here showing that the small cap universe has a lot of really marginal companies. So I'm going to walk through some of the charts that you could see in the piece that will help you understand this.
The first one is on free cash flow margin, where the large cap universe is crushing the small cap universe. And the small cap universe, we talk about both the S&P 600 and the Russell 2000. The S&P 600 has at least some criteria for being included, whereas the Russell 2000, if you have a pulse, you get included. And so portfolios that look like the Russell 2000 have, for many times over the last—for many periods over the last decade or so, have barely any free cash flow margin at all.
And similar story—if we look at the share of companies in the large cap universe that have negative earnings, it's around 40%. It used to be 25%. It's gone up to 40%, whereas in large cap, it's ranged anywhere from, let's say, 5 to 15%. So there's a lot of unprofitable companies. Some of them are probably smaller biotech and other healthcare.
Return on invested capital—large cap looks much better than small cap. Exposure to interest rates—the large cap stocks got the memo that during a decade of financial repression, you're supposed to extend the duration of your liabilities. Small cap—whether you look at the Russell 2000 or the S&P 600, they didn't. Still, only a little more than half the companies, about half the DOW outstanding in the small cap universe, is fixed. The rest is floating, whereas the floating component in the large cap S&P 500 universe is less than 10%.
So I don't know what screens they were looking at to go into this with so much floating rate debt. And because of that, if we look at debt to cash flow, obviously much higher for small cap companies compared to large cap, and then much worse returns. So cheap for a reason is how I've typically described small cap over the last 12 to 15 years because the companies were just so inferior in terms of their cash flow generation and their level of indebtedness. But as I mentioned earlier, everything has a price. So the question is, has the evaluation gap widened enough? Are you being paid for the risks in small caps?
I think we're getting closer. So let's take a look at what is driving the underperformance by sector and what—this chart, I think, is really interesting. My prior assumption is that small cap technology hasn't kept up with large cap but did OK. And it really hasn't. Over the last three, four years in particular, small cap tech stocks are flat at the same time that large cap tech has basically doubled.
This is really the biggest explanation or the most apparent one in terms of why small caps underperform. The technology companies in that index just don't do as well. And if we look across all sectors, it's not just technology where small cap underperforms large cap. It's also financials and healthcare, and consumer discretionary and consumer services, and energy and utilities. There's almost no sector where small cap has sustainably outperformed large cap. And so tech is the biggest piece of it, but it's not the only piece of it.
Now, so how cheap is small cap now? There's a lot of different ways to look at it. We look at it three different ways, and you come basically to the same conclusion, which is that small cap's cheaper than it's been at any time in the 21st century. You have to be very careful with valuation differences between two markets because the assumptions that are used to generate them could be different, like, for which indices you're using and which assumptions you're using.
The bottom line is pick an approach, stick to that approach, don't change the methodology, and then you can compare today's level to historical levels. But you can't kind of jump across metrics or indices. So, for instance, here the Russell 2000 we're looking at versus the S&P 500. I frankly don't understand how Bloomberg and the Russell 2000 are computing the PE ratio, given how many companies have no profits.
The PE ratio of a profitless company is either zero or infinite, like, you pick it. So I like to look at the S&P 600 better. Again, those multiples are 25% below large cap. That's the cheapest that it's been since 2001. And we also have a very messy chart, which is also helpful that there's this giant pump of all the different valuation metrics you could look at to compare the market pricing for small cap versus large cap—trailing PE, forward PE, cash flow, debt to cash flow, price to cash flow, price to book.
You kind of look at whatever you want, and they all pretty much have the same shape, which is they were really—small cap was really cheap around 25 years ago. It hit its peak expensiveness period in about 2012, 2013, and has been plunging ever since. And then, if we want to look at things on an earnings yield basis, we get a similar story. Earnings yield is simply the inverse of price to earnings. And it's useful with indices, where there's a lot of unprofitable companies with negative earnings.
And so not to get too caught up in the math and the methodology, the bottom line is no matter which metric you pick, you're getting the same story, which is small cap is as cheap as it's been since the year 2000. So that said, I just wanted to mention that as bad as small cap has done, it has still crushed international. Mean. International has really, really struggled. And as we saw earlier when we looked at a chart on earnings, the MSCI World ex-U.S.—I think I'm going to make everybody dizzy and go back to that chart for a minute. I want you to see this.
We have a chart in here that shows the MSCI World ex-U.S., both including and not including emerging markets. These earnings have barely gone anywhere since 2011. Outside the U.S. has been a earnings wasteland. And so that's why having such a big overweight to the U.S. has been so profitable. So anyway, I did think that was important to point out. So as bad as small cap has done versus large cap, it has outperformed emerging markets, and also Japan and Europe.
Now, sometimes people will say, well, is one of the reasons why small cap has struggled that there used to be a lot more companies that would go public as small cap that would be successful, grow into mid cap or large cap companies, but the small cap investors have reaped the benefits on the way up. Now that's not happening as much.
There is some evidence that that has happened. It's not just a kind of cocktail napkin theory. So we took all the tech IPOs since 2010, and from 2010 to around 2017, the market was dominated by companies that when they went public, were micro cap or small cap. And then a lot of these companies started to stay private longer, so that by the time they went public, they weren't small cap companies anywhere. They were mid cap or large cap.
And we have a chart here that shows that starting in 2018, the market shifted where 30% or less of the tech IPOs were still small cap. The rest were mid cap or large cap. So there is some truth to the notion that the companies that are staying private longer—and think the average life of a, of a tech IPO used to be maybe six or seven years, and now it's over 10. So there's some evidence that that's one of the things that's going on.
And the last question we sometimes get is, well, small cap has underperformed large cap. But if I pick a good manager, can I make enough money to offset the difference? And the answer is typically in the U.S., no. And typically outside the U.S., no. In emerging markets, probably.
So we have a table in here that—let me just use an example. Let's take a small cap core manager. Small cap, over the last three years, has underperformed large cap by 12 or 13%. The alpha, meaning the outperformance of small cap core managers, a median one is three-and-a-half. So you underperform large cap by 12% or 13%. You made back 3% or 4% with manager outperformance. Even a top-quartile manager might have only earned alpha of 6%, so clawing back like half the underperformance.
But the bottom line is small cap managers, unlike large cap, tend to have positive returns versus their benchmarks, but not by enough to erase the entire underperformance gap versus large cap stocks. So some good news and bad news there. Good news on small cap manager performance versus their benchmarks, but not big enough to make up the whole gap.
So anyway, that's the piece. Please take a look. I'm recording this on Sunday, which is the day before tomorrow's webcast we're going to be doing with Michael Morley, which you may already have seen. But if you haven't seen it, you can watch a replay. We're doing a webcast on the political implications of Biden's withdrawal with a constitutional law expert that we've worked with for the last few years. So anyway, thank you very much for listening, and talk to you again soon. Bye.
