Small caps are poised to come back… and lead once again

Despite the pullback in financial markets and an uncertain environment, small caps are poised for a comeback based on current market and economic fundamentals.

Article, July 7, 2022

Historical trends bode well for small caps in these uncertain times

This year has been incredibly bumpy for all stocks, but the ride has been most rocky for small caps. The U.S. small-cap benchmark, the Russell 2000, has been trending downward for the past few months, particularly since the beginning of 2022. As of May 31, the Russell 2000 Index is down 16.6% so far this year, underperforming the Russell 1000 large-cap benchmark by about 300 basis points. Even worse, since the last market peak achieved in November of 2021, U.S. small caps are down 23%, lagging large-cap stocks by a whopping 1,000 basis points.

Although small-cap stock losses have been painful, we at Van Berkom Global Asset Management would encourage investors to stay patient and consider the long-term attractiveness of small caps from these levels. There’s a very strong case for small caps to return to their historical outperformance and once again take a market leadership position.

Today, the outlook for small caps seems, at first glance, to be more uncertain and less exuberant than the amazing 20% annualized returns that U.S. small-cap stocks enjoyed from calendar year 2019 to the end of 2021, with three consecutive calendar years of doubledigit returns achieved by the category.

Markets are under pressure from recessionary sentiment

So why have small caps plunged so much over the past six months? In short, angst-ridden investors have become heavily focused on current inflationary and monetary policy pressures, pricing in the possibility of a near-term recession.

Just as the world was trying to turn the corner after two years of the Covid-19 pandemic, the uncertainty that the Russian invasion of Ukraine brings to an already volatile economic and market environment has set back a world trying to emerge from a global health crisis and return to normal life.

Since the beginning of the Russian-Ukraine conflict, the prices of oil, natural gas, gold and industrial metals have skyrocketed. Coupled with significant spikes in inflation around the world, worsening global supply chains and a significant tightening cycle well underway at some key central banks, there have been enough key headwinds to slam global equities, credit and many other risk assets quite hard.

As investor sentiment has soured with all these negative headlines and worrisome macro developments, there has been a broad selloff in global financial markets. Commodities have become the only place to be for investors and are a rare bright spot that has been a clear outlier across asset classes.

Small-cap stocks, in turn, have underperformed large caps, as larger stocks tend to hold up better in an unforgiving and uncertain macro environment and investors have yet to recognize the deeply depressed valuations, fundamental strengths and attractive long-term growth prospects of small caps.

All in all, a thick fog is clouding the efforts of investors to get a clear answer to these pressing questions: What will happen if world economies slide into a recession? How much lower can financial markets go? Plus, the biggest question of all: Where should I invest?

There’s a strong case for reallocating from large to small caps now

In our opinion, the right move to make today is to increase exposure to small caps with a long-term perspective in mind. Presently, investors are considerably underweighted in this asset class, yet historical data makes a strong case for reallocating from large caps and other asset classes to small caps these days.

Given the sharp pullback in equities worldwide — and in small caps, in particular — now may seem like exactly the wrong environment to recommend a reallocation from the “perceived” greater safety of large caps to the somewhat “riskier” profile of small caps, but that’s what we recommend to long-term investors.

It is important to note that we are really not trying to time the market — we do not know when and at which level the current bear market will end. However, we are convinced that investor portfolios with a multi-year investment horizon could reap huge rewards in the future by reallocating from large caps (and other categories) to small caps at these levels.

Small caps have a history of outperformance within an environment of rising interest rates, increasing inflation and growing GDP

When you look back over the past 50 years, small caps have outperformed large caps, even when the U.S. Federal Reserve significantly increased its benchmark interest rates. Therefore, we do not believe that the current cycle of significant tightening constitutes a structural headwind to small caps, consistent with solid historical evidence to that effect.

Total return across interest rate regimes
Small-Cap Returns in Times of Higher GDP, Inflation & Rates

Source: Federal Reserve Board; Haver Analytics; Center for Research in Security Prices (CRSP®), the University of Chicago Booth School of Business; Jefferies

This phase of the market and economic cycle augurs well for small caps

In addition to their solid historical performance in times of rising inflation and interest rates, small caps have outperformed large caps after the market bottoms, during the second half of a recession and coming out of a slump — at least nine out of the last 10 times. Why the outperformance? Smaller companies tend to show greater sensitivity to GDP growth as the economy comes off a trough, reacting to any “green shoots” in a weaker macro environment and quickly anticipating a significant recovery in the economy that disproportionately benefits smaller companies.

To investors who are deeply worried about a looming recession, we would also like to point out that the current correction in small-cap stocks since their last peak in November 2021 has been on par with the average decline in a bear market in this category and far greater than the typical pullback seen during the first half of a recession. This suggests that stocks in this universe, historically speaking, are already discounting a recession, protecting them from further significant downside risk from this point forward. We are not suggesting here that the market has bottomed, but we firmly believe that small caps, at their current valuations, offer tremendous value and should provide healthy long-term returns over the next three to five years — and beyond — for investors who opt to invest in this category at these levels.

Small is already pricing in a nasty recession…

Note: Peak to Trough performance is 11/8/2021-5/5/2022
Source: FactSet; FTSE Russell; Jefferies

Favourable fundamentals support the case for small caps

Despite the notable economic pressure points summarized above, most fundamentals for U.S. consumers and companies remain quite solid due to strong balance sheets and profitable income statements.

Earnings growth for U.S. small caps has remained very solid

Amidst today’s macro challenges, earnings growth for U.S. small caps has remained quite solid, far outpacing the earnings growth for large caps.

And small-cap company earnings growth should continue to outpace the earnings growth of large caps.

Solid earnings growth for Small Caps
As of December 31, 2021

Source: FactSet; FTSE Russell; Jefferies

Small caps are trading at very attractive valuations in absolute terms and relative to large caps

After a few years of relative under-performance versus large caps, small caps are trading at very attractive levels, both in absolute terms and relative to large caps. As can be seen in the chart below, small cap valuations, in absolute terms, are currently at multi-year lows, levels rarely seen in the past 30 years.

Small Cap Valuations at GFC* Lows

*Great Financial Crisis – 2008.

Relative Valuation for Small Caps Versus Large Caps

Note: Valuation model consists of relative Trailing and Forward P/E, Price to Book, Price to Sales and from 2002 Price to Cash Flow; from March 31, 2016 forward Jefferies’ estimates.

Small caps should see strong absolute returns going forward

Based on historical data, small caps should deliver excellent future absolute returns from their current levels— due to their significant correction, low valuations and reasonable, supportive bottom-up fundamentals.

Historically, small caps have bounced back considerably in absolute terms in subsequent periods when they trade at these lower levels.

Small caps should see strong relative returns vs. large caps going forward

After a few years of severe relative underperformance, small caps should also perform quite well relative to large caps going forward — based on their current level of relative valuations — as can be seen in the chart below.

When longer-term performance has been this bad, we tend to get snap back

Source: Center for Research in Security Prices (CRSP®), the University of Chicago Booth School of Business; Jefferies
*Current relative returns for small caps rank in Q5 (worst)

Based on historical trends, small caps should outperform large caps in future years in light of their current favorable valuations, superior earnings growth potential and mostly supportive macro fundamentals.


High-quality small-cap stocks should significantly outperform the overall small-cap market

With a highly uncertain macro environment, a tightening cycle in the works and significant inflation, high-quality small-cap stocks within our universe should significantly outperform the overall small-cap market.

Since high ROE/high-quality small-cap stocks have a strong history of outperformance versus low ROE/low-quality small-cap stocks and the overall small-cap market in this macro backdrop, we believe that a portfolio and investment style focused on high-quality small-cap stocks is essential for investors in this category.

Take the long view and tilt more to small caps

In conclusion, we understand that the past few months have been quite challenging for small-cap investors, as macro fundamentals have rapidly soured and become increasingly cloudy.

We also recognize that economic uncertainties, heightened geopolitical tensions and increasingly restrictive central banks have created a particularly inhospitable investment environment for small caps.

Investors could, nonetheless, reap huge rewards over the next few years by reallocating from large to small caps today — precisely because of the “perceived” potentially negative market and economic outlook and strong long-term fundamentals.

Regardless of the pessimistic perceptions out there, or maybe even because of them, we would argue that these potential negatives are more than adequately reflected in the extremely low absolute and relative valuations of small caps.

History convincingly points toward a strong rebound for small caps at some point over the next few quarters, both in absolute terms and relative to large caps.

For investors with a multi-year investment horizon, the current stage in the market and economic cycle bodes well for a major small-cap stock comeback.

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