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
Ready for the 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.
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.
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.
A potent mix for potential outperformance
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.
Final thoughts
As we move forward and navigate the complex economic landscape of interest rate cuts, recession concerns, and political uncertainties, we believe the small cap market stands ready to capitalize on the next wave of economic growth and innovation. The current valuation discounts compared to large caps, combined with the growth potential in various sectors, make this an opportune time to consider adding quality small cap stocks to a diversified portfolio.
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'.
Important information
Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed and actual events or results may differ materially.
Equity stocks of small and mid-cap companies carry greater risk, and more volatility than equity stocks of larger, more established companies.
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