A turning point for US small caps

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Despite the compelling history of small-cap strength, market participants cite four key reasons for small-cap underperformance:

• Small caps are more economically sensitive and thus often underperform in late-cycle environments.
• Small caps have more leverage and floating-rate debt and are therefore more exposed to higher interest rates.
• Small caps are structurally less attractive, as more low-quality companies have gone public within the small-cap spectrum in recent years.
• The best up-and-coming companies are staying private longer.

Below we address these four points head on. In broad terms, there is much truth in them. However, we think small caps are particularly attractive, even when considering these headwinds. There are nuances and exceptions to these points, yet current valuations reflect a more negative outlook. Finally, the disparity and dispersion within the small caps makes this asset class an especially attractive hunting ground for active managers seeking to add alpha.

Are small caps more economically sensitive and thus likely to underperform in a late-cycle environment?

True. Looking back at the last 30 years, there has been cyclicality in large and small profitability. As seen in the chart below, while large-cap margins have been consistently higher than in small cap companies, they expand and contract in unison. Through it all, small-cap margins have remained range bound. However, average large-cap company margins have trended higher than small-cap margins. This is largely a function of mega-cap tech stocks, where there has been dramatic margin expansion in recent years.

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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.

Are small caps structurally less attractive, as more low-quality companies have come public in recent years?

The percentage of small-cap companies with no profits (or no sales!) has risen dramatically. This has been a long-term trend accelerated by the SPAC boom of 2020–2022, with many venture-stage companies thrust into the public markets, especially in biotech.

Despite these entrants into the Russell 2000, small-cap profit margins overall have remained relatively stable. This indicates that profitable companies in the Russell 2000 are seeing strong growth in profits and margins. Yet, the market has punished all small companies equally, as profitable small caps currently trade at near an all-time valuation discount to large caps (on a forward P/E basis). This should provide ample opportunities for active stock pickers.

Are the best up-and-coming companies staying private longer?

While there is some truth to this, is it a risk or an opportunity? There are now 1200+ private unicorns (with valuations above US$1 billion) globally. This is up 50% from 2021 and up by more than 10 times since 2018. At the same time, the number of public companies listed in the US has steadily decreased since the peak in 1996.

While this has been a structural headwind for small caps over the past decade, we would argue that public small-cap investors now sit in an enviable position. Eventually many of these companies will need to come to public markets. This will likely be a buyers’ market for small-cap managers. With so many profitable public small-cap companies trading at large valuation discounts, there is no incentive to overpay for IPOs. Managers can wait for the private/public bid/ask to narrow.

Bonus question: Is the small cap asset class compelling for active managers due to its persistent inefficiencies?

We believe so. There are fewer analysts covering small cap companies — roughly four times as many cover the average large-cap company as do those following the average small-cap company. And while quantity is not necessarily an indicator of quality, we also see greater disparities between estimated earnings and actual reported earnings for smaller companies. These inefficiencies lead to twice as much return dispersion for stocks within the small-cap universe, creating a substantial alpha opportunity for active small-cap managers. In fact, the median manager beat the Russell 2000 Index 69% of the time and by 0.99% over 10-year periods (1978 through 2023).

In conclusion

We believe the long period of underperformance of small-cap stocks is nearing an end. The cyclical and structural arguments against small caps have some merit but have been broadly misconstrued over what is a diverse group of stocks. Also, starting points do matter, and the valuation gap between the two is unusually wide by historical standards. There is, obviously, no way to pinpoint the exact turning point. We can, however, have some degree of confidence about that point coming soon. As shown in the chart below, in the past, such a wide valuation gap has consistently resulted in outperformance of at least 5% annually for the following five-year period.

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