In investing, the allure of quick gains and the thrill of beating the market often overshadow the fundamental virtues that underpin long-term success. Among these, patience is not just a virtue but a strategic asset, especially when navigating the volatile waters of small-cap and international equities.

Over the last decade, the investment landscape has been markedly dominated by US large-cap equities, overshadowing their international and small-cap counterparts, which have underperformed in comparison.

However, this discrepancy does not necessarily paint a full picture of the potential that lies in patiently holding onto these underperforming assets.

Understanding Market Cycles

The investment world is a vast and complex ecosystem, where myriad factors interplay to influence the performance of different asset classes.

In recent years, the spotlight has often shone brightest on US large-cap equities, driven by the stellar performance of tech giants and other market leaders.

This has led to a skewed perception among investors, many of whom have come to view these large-cap stocks as the only viable path to investment success.

However, this overlooks the set of opportunities that lie within international and small-cap US equities, which have, admittedly, lagged in performance over the last decade.

History has shown us time and again that today's underperformers can be tomorrow's market leaders.

Economic cycles, changes in consumer behavior, and technological advancements can shift the balance in favor of different sectors and sizes of companies.

For example, during periods of economic recovery, small-cap stocks often outperform their larger counterparts due to their agility and the ability to innovate and capture new market trends rapidly.

Furthermore, the global economic landscape is continually evolving, with emerging markets presenting new growth opportunities that may not be available in more developed economies.

Investing in international equities offers exposure to these growth potentials, alongside the benefits of diversification.

The Case for Patience in Investments

Investing is as much about psychology as it is about economics. 

The patience to hold onto investments, especially those that are currently underperforming, can often differentiate between long-term success and short-sighted failure.

From a psychological standpoint, practicing patience helps investors avoid the pitfalls of emotional decision-making.

It's easy to be swayed by the latest market trends or news cycles, but such reactive strategies often lead to suboptimal investment decisions.

Patience, therefore, is not merely waiting; it's a strategic choice that acknowledges the cyclical nature of markets and the potential for long-term gains from diversified investments.

It requires a conviction in one's investment philosophy and an understanding that time in the market often trumps timing the market.

For investors in international and small-cap equities, patience is the linchpin that can unlock the door to significant long-term rewards, underscoring the importance of looking beyond the immediate to the immense potential that lies ahead.

Why Hold Onto Underperforming Investments?

When investing the instinct to cut losses and shift funds to better-performing assets can be strong.

Savvy investors understand that underperformance is not always a sign to sell.

Instead, it can be an opportunity to reassess, rebalance, and reaffirm commitment to a well-considered, long-term investment strategy.

Hanging onto these underperforming investments requires patience to harvest potential gains.

Here are some reasons to hang on:

Reversion to the mean: Over time, asset classes tend to revert to their long-term average performance relative to other asset classes. Periods of underperformance are often followed by periods of outperformance, as valuations and investor sentiment shift.

Diversification benefits: Maintaining exposure to international and small-cap stocks provides valuable diversification benefits, reducing overall portfolio risk and potentially enhancing long-term returns.

Contrarian opportunity: When asset classes are out of favor and underperforming, they may present attractive valuations and contrarian investment opportunities for patient investors willing to go against the crowd.

Long-term growth potential: Both international and small-cap stocks offer exposure to companies and markets with attractive long-term growth potential, which may not be fully reflected in their current stock prices.

The Case for Remaining Committed to Small Cap and International Equities

Despite recent underperformance relative to U.S. large-cap stocks, there are compelling reasons to maintain exposure to small-cap and international equities in a well-diversified portfolio.

Historically, these asset classes have exhibited periods of cyclical underperformance followed by impressive rallies as valuations revert to more normal levels.

Currently, small-cap and international stocks are trading at substantial valuation discounts compared to their U.S. large-cap counterparts. The S&P 500, our preferred proxy for US Large Caps, currently sports a price-to-earnings (P/E) of 24. By absolute valuation standards, US Lage Caps appear richly valued.

The degree of over-valuation is even more pronounced on a relative basis. US Small Caps carry a P/E of 12 while International Developed Equities possess a P/E of 15.

On a price-to-book basis (P/B) US large Caps look even more expensive. The P/B metrics for US Small Cap, International Developed, and Emerging Market Equities are below 2. In contrast, the S&P 500 has a price-to-book north of 4.

The valuation advantage of US Small Caps and International Equities could provide a tailwind for future returns as investor sentiment shifts and capital rotates into these relatively cheaper areas of the capital markets.

Moreover, small-cap and international stocks offer important diversification benefits, reducing overall portfolio risk through imperfect correlations with other asset classes.

These segments also provide exposure to different areas of the market, ranging from faster-growing small companies to flourishing international economies.

Maintaining a strategic allocation allows investors to participate in their potential upside as market leadership rotates over time.

Our quarterly asset class risk and return assessment favors US Small Cap and International Developed Market Equities over US Large Caps where we remain Neutral.

It’s also worth mentioning that the only reason we are Neutral in Emerging Markets is due to uncertainty surrounding the Chinese economy. Chinese equities appear undervalued, but geopolitical tensions and a slowing local economy make us extra cautious at the moment.

Current Asset Class Views:

From a long-term risk-return basis, we estimate a return premium to US Small Cap Equities of 2% a year, but with additional volatility. We assume the same for Emerging Market Equities.

Relative to Developed International Equities we expect US Large Cap to outperform by, on average, 0.5% per year due to the faster growth profile of the US market.

Asset Class Risk & Return Long-Term Assumptions:

The underperformance of US Small and International Equities is not likely to disappear overnight. Over the last 5 years, US Large Cap has returned 15.2% per annum exceeding our assumption for long-term returns.

In contrast, US Small Cap and International Equities have yielded returns over the last 5 years all below our long-term expectations. In particular, Emerging markets have been abysmal yielding only a 2.4% annualized return which is well below our 11% annualized return forecast.

We expect investor sentiment for these underperforming asset classes to shift with improving performance.

Investors are keenly aware that US Large Cap has been the place to be over the last decade, but also that nothing good lasts forever.

Small Cap and International Equities are the logical asset classes to diversify away from US Large Cap.

With patient investors often rewarded for adhering to well-structured asset allocations, now could be an opportune time to rebalance and remain committed to small-cap and international equity positions.

Their relatively attractive valuations and potential for improved sentiment may pave the way for a comeback after a prolonged cycle of underperformance.

• The path to success is rarely linear. Amidst the ebbs and flows of market dynamics, the virtue of patience stands out as a beacon for long-term investors, especially those brave enough to venture into under-performing asset classes such as US Small Cap[ and International Equities at the moment.

• Carson Block's insightful reminder that being right doesn't always equate to immediate financial gain encapsulates the essence of strategic investing. It highlights the importance of looking beyond short-term fluctuations and focusing on the broader horizon.

• In conclusion, investing beyond the now requires a vision that transcends the immediate, a strategy that embraces patience, and a mindset that values the potential of every investment. For those willing to be patient, the rewards extend far beyond the obvious momentum of today’s winners.

• Patience may not be the most exciting aspect of investing, but it is an indispensable quality for those seeking long-term success. By cultivating patience, investors can overcome the temptation to make impulsive decisions, stay the course during turbulent times, and ultimately reap the rewards of a well-executed investment strategy.

The Big Picture:

• Both US Small Caps and Real Estate investors enjoyed a good week (both up 1.3%). These two sectors have been significant underperformers in the last few years.

• The big losers last week were EM Equity investors. The MSCI EM Index was down 0.7% last week as Chinese equities once again experienced a loss (-1.8%).

• Cash is outperforming longer maturity bonds this year. Until there is more clarity as to the direction of Fed policy this situation is likely to persist.

• The investment environment remains risk-on. Aggressive asset allocation strategies continue their outperformance. Our Risk Aversion Inex (RAI) remains in the Exhuberant Zone.

Economy:

• The US economy continues to be strong. The biggest issue remains inflation and, of course, Washington infighting.

• Consumers have lowered their expectations for future inflation but remain traumatized by the sharp spike in prices of the last 3 years. Wage growth has somewhat offset the general increase in the cost of living but for those people living on fixed incomes, the pain has been widespread.

• Globally, economic conditions are not as robust as in the US. The Chinese economy has shown a significant slowdown triggered by overbuilding and excessive leverage in the housing sector. Europe remains on the verge of a recession while the UK is technically already in a contraction.

Equities:

• US Large Cap equities dominated the 1st quarter with a return of 10.6%.

• The performance of US equities in Q1 was inversely proportional to their market cap (Large > Mid > Small > Micro Returns)

• Growth strategies outperformed value strategies in Q1 despite some traditional value sectors such as Energy and Financials tallying top-notch returns.

• On the international front, the Japanese equity market continues its rebound. In Q1 the MSCI Japan Index was up 10.5%. Among major international markets, only Dutch equities performed slightly better (11.2%)

Bonds:

• Bonds overall had a good week. Year-to-date fixed-income strategies are still below historical norms. The wildcard remains Fed policy. After the latest inflation reports the odds of a June rate cut appear low. More likely we’re looking at the fall for any cuts.

• Long-maturity Treasury bonds gained last week as long-dated interest rates came down marginally while short rates stood firm. This is in contrast to the prior week.

• Year to date the performance of short-maturity bonds has trounced the return of long-maturity bond strategies. The iShares 20+ Year Treasury Bond ETF (TLT) is down 3.7% for the year.

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