Looking closer, unlike in 2021–2022, earnings and sales in the “Magnificent Seven,” which now constitute a large share of the cap-weighted large-cap indices, grew faster, and skewed large-cap index metrics higher than small caps despite slowing growth due to higher rates across the cap spectrum in 2023. While it has been impressive to see mega-cap companies buck the trend as the Fed pursued slower inflation through less accommodative monetary policy, we believe much of this is already embedded in valuations. Moving forward, we believe the differential in sales and earnings growth between large and small stocks is poised to narrow as we move through 2024 with an outlook for higher GDP growth and lower rates.
Do small caps have more leverage and floating-rate debt and thus are more exposed to higher interest rates?
There is no question that, on average, smaller companies have more leverage and more floating-rate debt than large companies. In fact, the share of rate-sensitive debt for small caps is more than triple that of large caps. All else equal, this is a structural negative for small caps in a weak economic environment with rising interest rates.
But while small caps have more debt on average, this debt is concentrated in a small percentage of companies. Half of the Russell 2000’s debt is held by just 10% of its constituents. Interestingly, 33% of Russell 2000 companies have net cash, compared to 13% of S&P 500 companies. In short, variable-rate debt is a big issue for many small companies, but it is not an issue for small caps broadly, highlighting an opportunity for active management.
Equity Market Outlook
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