Smaller companies typically have greater growth potential than larger more-established peers—making them attractive to investors seeking higher returns. Small caps are often overlooked from the institutional side, which can create opportunities for investors to find interesting companies at potentially attractive valuations.
At abrdn, we see four factors which may well set up small caps to outperform large caps: small cap valuations relative to large caps, a recognition that the Fed's actions may be leading to a recession, the declining (albeit elevated) inflationary backdrop, and accelerated activity in mergers and acquisitions (M&A).
Small cap valuations relative to large caps
Valuation
US small caps have historically traded at a premium to large caps, a recognition that investors need to be compensated for taking on additional risk. Small cap's decline in valuation has been driven in part by fears of economic slowdown. The chart below highlights that current relative valuations for small caps are near all-time lows—the biggest discount in over 40 years.
Chart 1. Small cap-relative-to-large cap forward price/earnings ratio
Source: FactSet, Bloomberg, abrdn, 31 March 2023.
Quality
One of the primary pillars of our US Small Cap strategy is investing in higher quality companies with sustainable business models that tend to provide downside protection while also participating in up markets. The chart below illustrates how higher quality companies, measured by return on equity (ROE), are trading at relative lows, according to price-to-sales and price-to-book ratios.
Chart 2. Russell 2000, Relative valuations: Q1/Q5 valuations-highest ROE vs. lowest ROE
Source: abrdn, Jeffries, 31 March 2023.
Is a recession in the cards?
As the Federal Reserve raises interest rates to thwart inflation, risks of an ensuing recession are rising. We continue to expect the US to enter a relatively short and shallow recession beginning in late 2023. Historically, small cap stocks underperform their larger brethren on the way into a recession, as has been the case during this cycle, while outperforming them coming out of a recession. Smaller companies' earnings tend to be more economically sensitive and therefore, experience more earnings deterioration when going into a recession yet tend to rebound faster as economic conditions improve. The three corresponding tables below reflect how small caps led the market both down into a recession – in this case, the Dotcom bubble (2000–2003), the Global Financial Crisis (2008–20011), and the pandemic (2020–2023) – but subsequently, then also up and out of that recession.
Table 1. Returns during periods from the past three recessions
Source: abrdn, FactSet, Bloomberg, 31 March 2023.
Declining (albeit elevated) inflationary backdrop
While we believe that we have seen the peak of inflation, the Fed's path to its mandated inflationary target of 2% is not linear. Historically, as illustrated in the following chart, when inflation is above 3%, but declining, has proven to be a good backdrop for small cap future returns.
Chart 3. 2023 inflation backdrop will be the "best case" scenario for small caps
Source: Center for Research in Security Prices (CRSP®), The University of Chicago Booth of Business; Jefferies.
And as reflected by 1-, 3-, and 5-year performance, as illustrated in the table below, for three major US asset classes during similar periods.
Table 2. Consumer price index (CPI) annual rate on large, mid, and small caps
Source: Center for Research in Security Prices (CRSP®), The University of Chicago Booth School of Business; Jefferies, 9 March 2023
M&A activity has accelerated
Low valuations and strong balance sheets set up well for M&A as companies look to buy growth. 2023 has seen a pick-up in M&A activity thus far this year having surpassed prior-year levels, and higher than the long-term average, as illustrated in the chart below. When M&A activity accelerates, small caps have historically risen nearly 16%.1
Chart 4. M&A is running ahead of last year's level (and much better than average)
Source: FactSet, Bloomberg; FTSE Russell; Jefferies
1. FactSet; Bloomberg; FTSE Russell; Jeffries.
Important information
The information contained herein is current at the time of distribution, intended to be of general interest only and does not constitute legal or tax advice. abrdn does not warrant the accuracy, adequacy or completeness of the information and materials contained in this document and expressly disclaims liability for errors or omissions in such information and materials. abrdn reserves the right to make changes and corrections to its opinions expressed in this document at any time, without notice.
Some of the information in this document may contain projections or other forward-looking statements regarding future events or future financial performance of countries, markets or companies. These statements are only predictions and actual events or results may differ materially. The reader must make his/her own assessment of the relevance, accuracy and adequacy of the information contained in this document, and make such independent investigations as he/she may consider necessary or appropriate for the purpose of such assessment.
Any opinion or estimate contained in this document is made on a general basis and is not to be relied on by the reader as advice. Neither abrdn nor any of its agents have given any consideration to nor have they made any investigation of the investment objectives, financial situation or particular need of the reader, any specific person or group of persons. Accordingly, no warranty whatsoever is given and no liability whatsoever is accepted for any loss arising whether directly or indirectly as a result of the reader, any person or group of persons acting on any information, opinion or estimate contained in this document.
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