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FRONT OF MIND | ARTICLE – 4 Min

The case for US small-cap stocks

By GEOFF DAILEY 29.09.2023

In this article:

    At the start of the final quarter of 2023, many small-cap stocks are trading at a significant discount to their larger-company counterparts, creating an attractive entry point. So says Geoff Dailey, Head of US Equities. In this interview, he explains why, he sees this as a good time to allocate to US small caps.   

    Geoff, let’s begin with valuations. How have US small caps traded recently?

    After lagging large caps in recent years, US small caps are currently trading at what I see as a wide and attractive discount relative to large cap stocks.

    Small caps had a difficult year in 2022, with the Russell 2000 index down by more than 20% for the year. At the start of 2023, sentiment was negative; inflation was proving sticky and all the talk was of an impending US recession. Not a great environment for stocks generally.

    Despite that, small caps had an outstanding start to the year, with the Russell 2000 rising by 10% in January. Several stocks in our portfolio rose by over 25% in that first month. The rally demonstrated the power of small caps when valuations are favourable and sentiment on the forward economic outlook inflects positively.

    In mid-March, the mini regional banking crisis derailed momentum, but the market recovered, leaving the Russell 2000 essentially flat over the first five months of the year. Then, as the US economy’s resilience became apparent, the market sprang to life through the summer. By mid-August, the index had returned more than 10% over the year to that point. 

    Since its peak this summer, the Russell 2000 small-cap index has fallen by 11%, while the S&P 500 fell by 7% as the prospect of slowing global growth and higher-for-longer interest rates tempered sentiment. In September alone, the small-cap index fell by 7%, leaving it over 27% below its all-time high in 2021, compared with 11% for the S&P.  

    Since the end of July, the Russell 2000’s price-to-book has fallen by 16% to 1.8, which is close to the biggest discount to large caps on record. When small caps have traded at this type of discount in the past, they have historically gone on to deliver strong returns over the following 12 months and tended to outperform large caps.

    If you compare the price-earnings ratios of profitable small caps (around a third of Russell 2000 companies are life science or tech companies that lose money) to large caps, they are trading at about a 30% discount — the widest gap since the peak of the tech bubble in 2000.

    We are cognizant of the risk of the lagged impact of tighter monetary policy and the higher-for-longer rate scenario, but in our view there are signs of a more optimistic base case for the US economic environment. US growth remained strong at 2.1% in the second quarter on the back of strong consumption and business investment. Consumer activity is still healthy, and services consumption has been steadily rising since the pandemic. The job market is robust and balance sheets among our US small-cap companies remain healthy. We see valuations as compelling and we expect the asset class to perform well once it becomes clearer that the US economy is not heading into a deep recession. In my view, we are at – or close to – a favourable entry point for US small caps.  

    Why do you advocate active management of allocations to US small caps?

    I am a big believer that small caps are an inefficient asset class and are better suited to an active approach. Firstly, there is less analyst coverage. The average number of analysts focusing on small cap stocks is about five on the sell-side, compared to around 25 analysts for mega caps and 15 for large cap stocks. That creates a lot of opportunity for rigorous fundamental analysis to identify idiosyncratic opportunities.

    Secondly, there are lower levels of liquidity, and with that comes greater volatility.  Our team of sector experts have views on the intrinsic value of stocks and we can use that volatility to our advantage.

    A third point on the inefficiency of the small-cap market is the immaturity of the firms. There is a greater variability in quality of management and maturity of capital structures among small-cap companies.  Having fundamental analysts evaluating the strength of the management team and assessing the strength of the balance sheet allows us to identify outstanding businesses.

    The last element I see in the case for an active approach is merger and acquisitions (M&A).  We are constantly talking to management teams. We know the types of products or services that are sought after and most likely to be acquired, as well as those management teams that are potential sellers. Acquisitions can be a large driver of outperformance within the small-cap portfolio. This is an area where we can add value through active management.

    Do you expect small-cap stocks to catch up on the performance of their large-cap peers?

    I think we will see small caps begin to catch up, although this is very hard to time.  A discounted small-cap valuation argument would have suggested a catch-up was due a year ago.  We are still at extreme levels of valuation with the price-earnings ratio of small caps relative to large caps close to the lows of the past 20 years. We expect that gap to narrow. 

    The timing depends somewhat on the ultimate path of the US economy. We do not expect a deep or prolonged US recession, but if it did occur, it would delay a recovery in small caps. We think better visibility of a soft landing would bolster a small cap recovery. Large caps would clearly benefit as well, but we think there is more upside to small caps under this scenario.

    To summarise, why should investors allocate to US small caps now?

    In my view, investors should hold a permanent, long-term allocation to US small caps to give them exposure to innovative, faster-growth companies, and to an asset class with a long-term track record of strong absolute and relative returns compared to other asset classes. Over time, valuations have proven to be a good indicator of the potential for longer-term outperformance. 

    There are periods when macroeconomic fears and negative sentiment weigh on valuations and create an opportunity for investors. Today, with the Russell 2000 forward price-earnings ratio at 20% below its 10-year average, we are at or near levels that we believe offer investors potential for outperformance in the longer run.  I think the pieces are in place for small caps to perform well.

    Disclaimer

    Please note that articles may contain technical language. For this reason, they may not be suitable for readers without professional investment experience. Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice. The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns. Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions). Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

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