Smaller companies – typically valued between $250 million and $5 billion – hold immense potential to disrupt established industries and become tomorrow's market leaders. Historically, due to their higher debt and floating debt rate, small caps make them adversely exposed to the higher-for-longer interest rates regime but tend to outperform when exiting a recession or periods of accelerating economic growth.
Unfortunately, with higher-for-longer rates and stickier inflation, we have not yet seen a pivot to small caps. While investors are left feeling rather sceptical, we believe it is an ideal opportunity to revisit small caps.
We delve into the current landscape of US small caps, highlighting the challenges, opportunities, and enduring value proposition for investors with a long-term perspective.
A deserved place in the portfolio
Small caps offer several advantages over their large cap counterparts. They tend to be:
More nimble and adaptable
Freed from the bureaucratic burdens of larger companies, small caps can adapt quickly to changing market conditions (like when the Federal Reserve decides to lower rates) and capitalise on emerging trends.
Higher growth potential
Fuelled by innovation and a drive to establish themselves, small caps often exhibit high growth rates, translating to significant potential returns for investors.
Diversification
Including small caps in your portfolio offers diversification benefits. It mitigates risk by reducing exposure to any single asset class, including large cap US equities.
Actively managed small cap funds add another layer of benefit. Skilled portfolio managers can leverage their deep research capabilities to identify undervalued gems and navigate the complexities of the small cap space.
Setting the scene
US economic growth has shown resilience, benefiting from easing supply chain pressures, lower energy costs, and increased productivity. However, tighter credit conditions and reduced household savings have tempered this growth, balancing the likelihood between a soft landing and a mild recession as inflation moderates. Consequently, Chairman Powell has increasingly signalled the potential for an interest rate cut, with current expectations leaning towards the first cut in September.
Regarding the markets, small caps have struggled to capture investor attention amidst the continued dominance of large cap growth stocks. While the initiation of a new Fed rate cut cycle may offer some support, sustained outperformance by small caps will hinge on avoiding a recession and bolstering positive underlying fundamentals within smaller companies. Historically, small cap stocks have posted average returns of 14% and 27% over the six-month and one-year periods following the first rate cut. Large cap stocks have yielded returns of 9% and 16% over the same periods. [1]
Against this backdrop, we believe the outlook for small cap stocks remains positive for several reasons:
- Small cap stocks trade at a significant discount compared to their larger counterparts. We expect a broadening out of the market away from the Magnificent Seven as investors grow more confident in the direction of the Fed’s rate policy. [2]
- Corporate balance sheets are flush with cash, often triggering merger and acquisition activity, with smaller companies historically benefiting.
- Higher-quality companies continue to be inexpensive relative to lower-quality companies, which is a core investment tenant of the small cap strategy.
The ups & downs in the small cap arena
US equity markets have been narrow, driven mainly by large cap US growth and tech companies. This narrowness has led to US small caps being ignored, potentially creating attractive valuations for many small companies with solid fundamentals.
Despite these challenges, we believe the long-term potential of US small caps remains attractive. This can be attributed to several factors, including:
Innovation powerhouse
Small companies are often at the forefront of innovation, driving progress across various industries. While certain technology companies, including several in the semiconductor sector, have continued to outperform consensus expectations given their strong growth prospects in artificial intelligence, the substantial costs of investing in this field have been an investor concern.
Undiscovered gems
The inefficiency of the small cap market allows skilled managers to find undervalued companies with immense growth potential.
Long-term growth trajectory
Despite short-term volatility, history suggests that small caps outperform large caps over extended periods.
Why active management
In a more challenging environment, the ability to actively select high-quality companies becomes even more valuable. Despite short-term fluctuations, the US economy's inherent dynamism suggests continued small cap innovation and growth over the long run.
This is where active management shines. Small caps possess several inherent qualities that make a fertile environment for active management – more so than large caps. Skilled portfolio managers can actively research and select companies with strong fundamentals and high-growth prospects. Unlike passively managed index funds, they can also adapt more agilely to changing market dynamics.
Final thoughts
US small caps may have been ignored and passed over, but their long-term growth potential remains undeniable. By understanding the challenges and opportunities and embracing the strengths of active management, investors can position themselves to capture the rewards of this dynamic market segment.
With potentially attractive valuations and a focus on active management, a strategic allocation to US small caps could be the right move to fuel portfolio growth over the long term.
- ASI, FactSet, Bloomberg, June 2024.
- The 'Magnificent Seven' stocks are a group of the most influential companies in the U.S. stock market that consist of Alphabet (GOOGL; GOOG), Amazon (AMZN), Apple (AAPL), Meta Platforms (META), Microsoft (MSFT), NVIDIA (NVDA), and Tesla (TSLA).