Last year was terrible for equities. A war in Ukraine, soaring inflation, higher interest rates and weak economic growth all weighed on sentiment. Globally, both small and large caps were firmly in negative territory. Large-cap indices like the S&P 500 were dragged down as technology companies (such as Meta and Tesla) and stocks with high valuations sold off. Meanwhile, risk-averse investors shunned small caps as economic conditions deteriorated.

And what about the future? Given the gloomy backdrop, investors are likely to avoid smaller companies for much of 2023. On the surface, this decision seems understandable. History shows that smaller companies tend to underperform larger ones during economic downturns. But dig a little deeper and a surprising conclusion presents itself: the time to start allocating capital to small caps might be sooner than investors think.

Small caps outperform earlier than expected

There are widely agreed assumptions about the performance of smaller and larger companies in different economic scenarios. Chart 1 shows the relative average performance of US small caps versus large caps, before, during and after recessions (dating back to the 1980s). Of course, each recession is different, with different mechanisms at play. Nonetheless, three factors stand out.

Chart 1

Source: Bloomberg, William Blair Equity, December 2022

Firstly, larger companies tend to outperform their smaller rivals before, and at the start of, recessions. This makes sense. In economic slumps, risk-averse investors typically favour safer assets. In the equities space, this means more mature, well-established larger companies. Their markets are often less volatile and earnings more stable. By contrast, investors view smaller companies as riskier investments. Many businesses aren’t as entrenched as bigger firms. Earnings and profit margins can therefore come under pressure in times of upheaval.

Secondly, these factors are turned on their head when we exit a recession. In recovery periods, smaller companies usually outperform their larger rivals. By their very nature, small caps are nimbler and able to react faster than large caps to changes in the business environment. Smaller firms can therefore take advantage of the new opportunities a growing economy offers. The consequent rise in investor risk appetite also helps smaller companies.

So far, so predictable. But the third point is not widely known: smaller companies have historically started outperforming large caps soon after a recession starts. As you can see from Chart 1, this rebound can begin as early as three-to-six months into a recession. That’s because the market tends to price in an economic recovery before it happens. Yet this phenomenon is not part of the traditional small/large-cap narrative. We believe this disconnect creates opportunities for active investors.

A potentially attractive entry point

Smaller companies trailed their larger peers in 2022. In Europe, it was the worst relative year since comparative data began (see Chart 2). This has had a knock-on effect on valuations. Historically, European smaller companies have traded at an average premium valuation of 21%¹ above that of larger peers, thanks to superior small cap growth and earnings potential. However, at the close of last year, this difference dropped significantly and is currently at 9%. Given the potential rebound as we exit recession, this could represent an attractive entry point for long-term investors.

Chart 2

A similar dynamic is at play in the US. Here, the valuation discount of small caps relative to large caps is as wide as it has been in more than 40 years (Chart 3). We believe this creates excellent long-term opportunities. Indeed, after US small caps reached a similar level of ‘cheapness’ in early 2001, small-cap stocks materially outperformed larger caps over the subsequent three-, five- and 10-year periods¹.

Chart 3