We explore the current state of small cap investments and highlight different geographies that may offer other opportunities for discerning investors.
The current climate
Small cap stocks, typically defined as companies with a market capitalization between $300 million and $2 billion, are currently trading at attractive valuations across global markets (Chart 1). Notably, these smaller companies are often priced at a discount compared to their large cap counterparts, presenting an intriguing proposition for value-oriented investors.
Chart 1. Small cap relative to large cap forward price-to-earnings ratio (P/E)[2]
The allure of small caps lies in their potential for rapid growth and the possibility of outsized returns. Unlike large, established companies, small caps often have more room for expansion, allowing the asset class to be more nimble in adapting to certain market shifts. Small caps have shown a tendency to outperform in the early stages of an economic recovery and during periods of falling interest rates (Chart 2).
Chart 2. When rates do start getting cut, historical data is very supportive of smaller companies
US small caps ready to capitalize on economic upside?
The performance of small cap stocks in the US has been characterized by periods of significant outperformance interspersed with challenges. Coming into 2024, small caps have shown signs of resilience. While performance has been mixed, there have been periods of outperformance, particularly when economic data has surprised to the upside or when there have been indications of potential interest rate cuts.
The outlook for small cap earnings and performance is underpinned by a confluence of favorable factors that paint a promising picture for this dynamic market segment.
The outlook for small cap earnings and performance is underpinned by a confluence of favorable factors that paint a promising picture for this dynamic market segment. The economy's resilience continues to provide a solid foundation for small caps, whose domestic focus positions them perfectly to capitalize on improving local economic conditions. This economic backdrop, coupled with the interest rate cut by the Fed and the potential for more, sets the stage for a potentially favorable environment. Lower borrowing costs could stimulate economic activity, providing a tailwind for small cap growth.
Attractive valuations …
Valuations for small cap stocks continue to appear appealing compared to historical averages, especially in contrast to their large cap counterparts. Additionally, small cap companies represent only 3.7% of the equity market, a significant decrease from their 7.3% historical average.3 This suggests that there may be potential opportunities for investment in small cap stocks, in particular as investors look to invest the large amount of cash sitting on the sideline.
This valuation disconnect presents a compelling opportunity for investors, ...
This valuation disconnect presents a compelling opportunity for investors, offering potential upside as earnings improve and market recognition follows. As the investment landscape evolves, we're witnessing a shift in investor focus beyond the dominant large cap tech sector. This rotation is likely to benefit small caps in sectors such as industrials, consumer discretionary, and healthcare, areas ripe for innovation and growth.
… Innovation, agility, and growth potential
Indeed, innovation and agility are hallmarks of the small cap space. Many companies stand at the forefront of their industries, pioneering new technologies and business models. Their ability to adapt swiftly to changing market conditions is not just a survival tactic but a driver of potential earnings growth. This innovative spirit and an anticipated uptick in mergers and acquisitions activity could further energize the small cap sector. The prospect of buyout premiums and increased investor interest adds another layer of potential upside.
As we look to the future, sustained earnings growth will be the linchpin of small cap outperformance. The most promising opportunities, we believe, lie with companies that boast strong balance sheets, clear paths to profitability, and distinct competitive advantages in their markets.
While challenges such as geopolitical tensions, inflation concerns, and political uncertainties may introduce some volatility, the underlying strengths of the small cap market remain compelling.4 The combination of favorable economic conditions, attractive valuations, and small caps' inherent agility creates a potent mix for potential outperformance.
As we move forward, the small cap market stands ready to capitalize on the next wave of economic growth and innovation.
Global opportunities in small caps
Beyond the US, the small cap universe is diverse and spans various geographies, each offering unique opportunities:
Quality key for international small cap success
International small cap stocks offer different opportunities, but the focus on quality becomes particularly crucial in today's market environment. The importance of prioritizing quality in international small cap investments stems from several key factors shaping the global economic landscape.
First and foremost, the global economy continues to navigate uncertain waters. Varying rates of post-pandemic recovery, ongoing geopolitical tensions, and disparate monetary policies across regions create a complex backdrop for international investments. In this environment, quality small caps – those with strong balance sheets, sustainable business models, and effective management teams – are better positioned to weather economic storms and capitalize on opportunities as they arise.
Countries with stronger regulatory frameworks and transparent business practices tend to foster higher-quality small cap opportunities.
The concept of quality in international small caps extends beyond mere financial metrics. It encompasses factors such as corporate governance, which can vary significantly across different markets. Countries with stronger regulatory frameworks and transparent business practices tend to foster higher-quality small cap opportunities. Investors need to be particularly discerning in markets where corporate governance standards may be less stringent, which can significantly impact long-term performance and risk.
Another critical quality aspect of international small caps is their competitive positioning within their respective markets. High-quality small caps often possess unique intellectual property, strong brand recognition in their local markets, or operate in niche sectors with high barriers to entry. These characteristics can provide a degree of economic moat, allowing these companies to maintain profitability even in challenging economic conditions.
The potential for currency fluctuations in international investing further underscores the importance of quality. Quality companies with strong cash flows and prudent financial management are generally better equipped to handle currency volatility, which can significantly impact returns for international investors.
Emerging market small caps poised to drive future growth
Emerging markets (EM) present unique and compelling opportunities for small cap stock investors. The outlook for growth in EM small caps is promising, driven by a combination of demographic trends, economic reforms, and technological advancements. After experiencing a strong recovery following the COVID-related downturn, we are confident in the potential of smaller companies in this dynamic market (Chart 3).
Chart 3. Relative performance of small and large cap indices
We believe India deserves special attention as a critical driver of growth in the EM small cap space. Several factors contribute to the South Asian country’s importance, including robust economic growth, as India consistently ranks among the fastest-growing major economies in the world. This macroeconomic strength provides a favorable backdrop for small cap companies to expand and thrive.
Additionally, India’s demographic advantage, with one of the world’s largest and youngest populations, offers a vast market and a growing workforce. This demographic dividend is expected to fuel consumption and economic growth for decades to come.
Furthermore, India’s rapid digital adoption, exemplified by initiatives like the Unified Payments Interface and the widespread mobile internet use, creates numerous opportunities for innovative small cap companies in sectors such as fintech, e-commerce, and digital services.5
Lastly, government initiatives like “Make in India” and “Digital India” are fostering entrepreneurship and supporting small and medium-sized enterprises, providing a supportive ecosystem for small cap companies to grow and innovate.6
We believe the coming decades are likely to see EM small caps play an increasingly pivotal role in shaping global economic narratives.
As EMs evolve and mature, small cap companies are poised to be at the forefront of transformative change, driving innovation and economic growth across diverse sectors. These agile enterprises, deeply attuned to local market dynamics, are uniquely positioned to capitalize on the rising consumer class, technological advancements, and ongoing economic reforms characteristic of emerging economies. We believe the coming decades are likely to see EM small caps play an increasingly pivotal role in shaping global economic narratives, from groundbreaking fintech solutions in India to innovative manufacturing processes in Southeast Asia.
For discerning investors with a long-term perspective, EM small caps offer an unparalleled opportunity to participate in the next chapter of global economic expansion. As these companies tap into vast, underserved markets and leverage cutting-edge technologies, they can potentially deliver substantial returns.
The story of EM is one of rapid development, increasing sophistication, and boundless potential – a narrative in which small cap companies are set to be leading protagonists. By embracing the dynamism and growth prospects of EM small caps, investors can position themselves at the cusp of what promises to be one of the most compelling investment themes of the 21st century.
Article adapted from a recent Pensions & Investments-sponsored webinar, “Seizing the moment: Small cap opportunities in today's market.”
1 Small caps refer to companies with a smaller market capitalization. Small cap is an abbreviation of "small market capitalization."
2 Price-to-earnings ratio (P/E) is the current market price of a stock divided by the earnings per share. P/E ratios are often used to compare companies in the same industry, or to assess the historical performance of an individual company; a high ratio suggests that investors are expecting higher earnings growth in the future.
3 Center for Research in Security Prices (CRSP®), The University of Chicago Booth School of Business; Jefferies, August 2024.
4 Volatility is used as a measure of risk. It refers to the price of a fund moves significantly over a short period of time it is said to be 'volatile' or has 'high volatility'. If the price remains relatively stable it is said to have 'low volatility'.
5 "UPI continues to be the preferred choice of payment method in India." Telangana Today, September 2024. https://telanganatoday.com/upi-continues-to-be-the-preferred-choice-of-payment-method-in-india.
6 "‘Make In India’ Ten Years Later: Speed Bumps And Roadblocks." Forbes, September 2024. https://www.forbes.com/sites/vasukishastry/2024/09/24/make-in-india-ten-years-later-speed-bumps-and-roadblocks/.