We believe that there are always reasons for investors to consider U.S. small-cap stocks for their portfolios, and the asset class remains compelling today, even in light of recent strong performance.

Since the early days of the coronavirus crisis, when U.S. markets floundered, domestic small caps have rebounded well. So well, in fact, that the asset class, as represented by the Russell 2000 Index, returned 134% from the market bottom on March 23, 2020 through June 30, 2021. This trumps the broader U.S. equity market, as represented by the S&P 500 Index, which returned 96% over the same period (Table 1).

Small caps – higher risk, higher reward?

Investors have long viewed U.S. small caps as more risky than large caps, and not just because their shares are less liquid. Smaller companies generally have less access to capital and fewer financial resources. They often lack operational history and have less-proven business models. Furthermore, small caps tend to have lower analyst coverage, which can potentially hinder informed decision-making.

Smaller companies are especially at risk during market downturns for these reasons. During most historical market dips, their share-price performance has suffered more than that of larger companies. As expected, during the early days of the pandemic, when markets tumbled and economic prospects dimmed, the performance of small caps 'took it on the chin' versus that of their large-cap counterparts.

But with these risks comes the potential for reward. Shares of small-cap companies present strong long-term return potential versus large caps, which may compensate investors for assuming these higher risks. And some of the very elements of small-cap investing that make it a riskier endeavour can also provide greater opportunity.

Because the companies are small, they have more room to grow. They can be more flexible than large caps, adapting to changing market conditions. Less analyst coverage in this space allows for a better chance for active managers to find undervalued, overlooked 'hidden gems.' This leads to greater opportunities to generate alpha than can be found among the well-researched larger cap stocks.

Chart 1: Smaller companies over the long term
Growth of $100, small caps vs. large caps

Source: ASI, Factset, Bloomberg as of June 30, 2021. Past performance is not an indication of future results. Indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses are reflected. You cannot invest directly in an index. No fees or expenses are reflected. For illustrative purposes only.

Spreading risk, improving diversification?

Small caps may help investors diversify effectively compared to a portfolio with all the eggs in a large-cap basket.

For one thing, the small-cap asset class tends to have different exposure to the various U.S. sectors than large cap. Compared to large caps, small caps have a higher weight to healthcare, for example, as well as industrials and financials. Large caps, on the other hand, have a much higher weight to information technology (IT) and communication services. This different sector allocation helps improve diversification alongside a large-cap portfolio.

Source: Aberdeen Standard Investments, BPSS, Datastream, as of June 30, 2021

The five FAANG companies (Facebook, Amazon, Apple, Netflix and Alphabet/Google) also comprise a disproportionate representation within the S&P 500 Index — nearly 17% of its market cap. Consequently, moves within any one of these companies can have a material influence on the S&P Index’s returns. Conversely, the five largest stocks in the Russell 2000 Index carry a combined index weight of 1.9%. As an asset class, small-cap equities carry less concentration risk, helping to serve as a nice complement to large-cap allocations.¹ 

Post-bear-market outperformance

Strong economic recovery is underway in the U.S. and around the globe attributable to a combination of vaccine distribution, economic reopenings and fiscal support. In periods of economic recovery, smaller companies tend to outperform larger caps due to more domestically oriented exposure and higher operational leverage, among other factors (Table 1). Historically, in fact, small caps have delivered the strongest absolute performance during recovery phases when GDP is greater than 4%.

Source: ASI, FactSet, Bloomberg as of June 30, 2021. Past performance is not an indication of future results. Indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses are reflected. You cannot invest directly in an index. No fees or expenses are reflected. For illustrative purposes only.

Small caps in 2021 — taking a breath

Shares of U.S. small caps started strongly in 2021, but have significantly lagged their large-cap counterparts since mid-March (Chart 3). This is partly because, compared to the S&P 500 Index, the Russell 2000 Index carries materially higher exposure to cyclical areas of the market, such as financials and industrials. Over the past few months, these sectors have underperformed after a period of strong outperformance. Meanwhile, IT and communication services — sectors that carry higher weight in the S&P 500 Index — have outperformed during this same period. This reflects investors’ rotation back into more growth-oriented areas of the economy.

Source: FactSet, as of June 30, 2021

Rotation away from value-oriented sectors toward growth helps explain part of the recent relative underperformance of smaller-cap company shares. However, market participants may also be temporarily shifting focus after a period of strong small-cap returns. History suggests that the cycle of small-cap outperformance is not over, perhaps just taking a breath. In the past, post-bear-market cycles of small-cap outperformance have lasted more than five years on average. However, small caps have tended to exhibit pauses in outperformance during the first couple years of the cycle — similar to the current period.² 

Valuations support small caps today

While the relative discount of small caps to large caps has started to rebound somewhat, U.S. small caps still trade near their largest discount in 20 years. Notably, after small caps reached a similar level of 'cheapness' in early 2001, smaller-cap companies materially outperformed larger caps over the subsequent three-, five- and 10-year periods.³ 

The small-cap discount to large caps has grown in recent years. This growing discount is attributable in part to the different sector compositions of the U.S. large- and small-cap indices, as noted above. Perhaps most notable is the significantly higher weight to the IT sector in the S&P 500 Index, which has resulted in a disproportionately higher return contribution from this sector in recent years. Within this large-cap index, IT rose nearly 130% during the three-year period ended June 30, 2021, which translates to more than 40% of the index’s total return over this period.⁴ 

On the other hand, while the IT sector has also been the top-performing sector in the Russell 2000 Index over the past few years, its contribution to the index’s total return has been much lower due to its lower sector weight. Among small-cap equities, IT stocks returned 85% over this period, contributing a bit more than 25% of the Russell 2000 Index’s 46% total return.

Additionally, the Russell 2000 Index has a higher weight in the financials sector than that of the S&P 500 Index. Financials, which tend to comprise a more value-oriented area of the market, have performed relatively poorly in recent years. Consequently, they’ve been more of a drag on the return of smaller-cap indices.

Economic dynamics bolster the small-cap outlook

In our view, developments on the economic and policy fronts could give small caps a boost. President Joe Biden’s “Build Back Better” infrastructure proposals are making their way through the Congressional review process. While clarity around the outcome remains to be seen, there will inevitably be an increase in infrastructure spending. We believe that this political development should favour smaller companies over their larger counterparts, supporting a compelling investment case.

Corporate capital spending as a percentage of operating cash flow has been relatively low in recent years. Consequently, companies today are sitting on high levels of cash. Looking forward, we feel that companies are likely to put this cash to work. Capital spending has already picked up in recent months, but major infrastructure investment should accelerate this further. We expect this to benefit small companies because their top-line growth is more correlated to capex growth than larger companies. This because smaller companies tend to be more domestic, which makes them potentially greater beneficiaries of U.S. capex spending and GDP growth.

Furthermore, the more cyclical nature of smaller caps leads to greater sensitivity to capex growth compared to larger caps. This is because larger companies are more defensive and secular growth-oriented and, therefore, tend to be less tied to capex. We think that infrastructure spending will likely provide a boost to certain recipient sectors, including industrials, energy and utilities, all of which are more greatly represented among smaller caps.

In our view, high cash levels are also likely to lead to an increase in stock buybacks, dividend increases and mergers and acquisitions (M&A) activity. In fact, April 2021 was the strongest month for M&A activity since June 2016. Higher levels of M&A support smaller-cap stocks, as they are often the target of acquiring companies that are willing to pay a premium for shares of the smaller company.

Smaller caps have historically outperformed in the mid-cycle stage of an economy, too. This is typically the stage where inflation is the strongest. For example, in the late 1960s, expectations for U.S. interest rates and inflation started to rise after a prolonged period of low and stable inflation and interest rates. It’s necessary to note that comparisons of time periods are never perfect. However, given the current reflationary environment and the potential of new beginnings of a capex cycle, this historical pattern suggests the potential of small caps outperforming large caps in the near term.

Remembering the risks

While we believe that there are many dynamics that support small-cap equities, there are, as always, risks to the near-term outlook, as well. An unexpected setback in economic recovery could dampen our small-cap outlook. If, for example, Covid variants gain momentum and movement restrictions become necessary again, economic recovery could falter. In this scenario, investor sentiment would likely turn negative and investors may turn toward lower-risk areas of the equity market, away from small caps, which would most likely take a hit.

So, too, could a significant increase in inflation expectations. For example, a big increase in wages that erode profit margins — thanks to higher employee/sales ratios of small caps versus large companies — could be particularly threatening. At present, while we recognize the recent inflation pressures, we do not believe the U.S. economy is on a path toward permanently higher inflation. Nonetheless, this is a risk that market participants will be monitoring closely.

Finally, the prospect of U.S. corporate tax reform leading to rising taxes is a risk for small caps. While many U.S. companies will be affected under a scenario of rising taxes, the more domestically driven nature of revenue and profitability leaves small caps potentially more affected than larger, multinational companies.

Considering small caps today and tomorrow

We believe that the risks hanging over the small-cap equity outlook pale in comparison to economic dynamics, relative valuations and historical patterns that support it. In our view, there are always reasons to consider small caps as part of a well-diversified investment portfolio, but, right now, as the post-pandemic economic recovery accelerates and greater infrastructure investment looms, we see particularly timely opportunities in the asset class.

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