Is the small cap bear done roaring?

The global economy has recently weathered significant disruptions—from the COVID-19 pandemic and inflationary pressures to supply chain challenges and geopolitical tensions. These factors have introduced a high degree of uncertainty, prompting investors to seek safety in larger, more established companies—a shift which has notably impacted small-cap stocks that have underperformed relative to their large-cap counterparts.

Over the past three years in the US, the Russell 2000 Index—a proxy for small-cap stocks—underperformed the S&P 500 significantly. During this period, the S&P 500 gained 31%, while the Russell 2000 posted a 6.8% loss—a valuation gap of historic levels. In fact, based on metrics like price-to-book value, small caps have been trading in the bottom decile of their historical valuation range since 1990 relative to large caps [source].

And it’s not just in the US: between November 2021 and October 2023, European small caps also experienced a substantial correction of approximately 25% in relative terms. Currently, European small-cap stocks are trading at historic lows relative to large caps, with forward price-to-earnings (P/E) ratios around 14.2x compared to the historical average of 19.1x for the broader market [source].

A closer look reveals that the de-rating of small-cap stock can be attributed to a cumulation of several factors:

• Economic sensitivity: smaller companies tend to be more sensitive to economic cycles. While they often outperform during periods of economic expansion, they also tend to underperform during recessions. The anticipation of an economic slowdown in the markets has adversely affected investor sentiment toward small caps.
• Interest rates and macroeconomic uncertainty: small-cap companies are more vulnerable to rising interest rates and macroeconomic uncertainty due to their reliance on debt financing and greater exposure to cyclical sectors. With higher interest rates increase borrowing costs, this can impact profitability and growth prospects.
• Supply chain disruptions: industries like healthcare, industrials, and consumer discretionary—which constitute a significant portion of the small-cap universe—have been hit hard by supply chain disruptions and extended destocking periods. These challenges have affected production schedules and revenue streams.
• Perceptions of local exposure: there is a common perception that small caps are more locally focused and closely linked to government policies, which can introduce additional risk. While some small-cap companies are indeed more domestically oriented, many have substantial international operations. This misperception generally leads to an additional unwarranted negative bias against small caps.

Put together, these factors explain why unease among investors has grown, especially those under short-term performance pressures—leading to a reduction in small cap exposure or avoidance of the asset class altogether. Additionally, the lack of liquidity in small-cap stocks has made them less attractive compared to large caps in 2023 and early 2024.

The 25% valuation difference observed by the end of October mirrors levels seen during the Global Financial Crisis. But it’s not all doom and gloom though. Unlike the crisis period, this recent derating has not been accompanied by a material difference in earnings growth between small and large caps. Actually, there are signs that the derating of small caps may have bottomed out. Risks have either diminished or not materialised as feared—leading to a substantial improvement of the asset class’s risk-reward profile. Coupled with attractive valuations, these factors can present an attractive buying opportunity for long-term investors.

More concretely, we’ve identified several positive factors that suggest a more favourable outlook for small caps:

• Easing inflation and supply chain issues: inflation is coming down, supply chain disruptions have been largely resolved, and energy prices have normalised. These improvements reduce some of the macroeconomic pressures that have weighed on small caps.
• Interest rate environment: central banks, such as the European Central Bank (ECB), are signalling potential rate cuts. Lower interest rates can reduce borrowing costs for small-cap companies, enhancing their profitability and investment capacity.
• Chinese stimulus: the European economy is particularly sensitive to the Chinese economy. At the end of September, Chinese policymakers announced a raft of new stimulus measures. While many of these measures have been seen in isolation over the last year, such as cuts to interest rates or reduced downpayment requirements for home purchases, the coordinated nature of September’s announcement was the clearest signal yet that Beijing stands ready to support the Chinese economy and markets.
• Increased M&A activity: merger and acquisition activities have picked up, with private equity firms returning to the market. These firms are sitting on significant amounts of "dry powder," indicating they see value in current small-cap valuations.

Clearly, a rebound is a real possibility for the small-cap universe. However, capturing this bounce-back is not always easy. While small caps make up 15-20% of total market capitalisation, they account for 80-85% of all listed shares. This vast universe can make it challenging for investors to identify the right high-quality opportunities.

Moreover, markets tend to follow earnings growth. Historically, small caps have delivered stronger earnings growth compared to large caps over the long term. However, the greater number and volatility of small-cap stocks require careful selection and timing.

In European small caps specifically, active management plays a critical role due to limited research coverage and higher volatility. Approximately 90% of European small and mid-cap stocks receive minimal analyst coverage. This lack of attention creates inefficiencies and opportunities for skilled managers to uncover undervalued companies. By focusing on company fundamentals and conducting in-depth analyses, active managers can identify companies with strong balance sheets, innovative strategies, and high earnings potential. They also avoid underperformers by sidestepping companies with weak prospects that might otherwise have undue weight in a passive index.

The benefits of active management are even more pronounced in the small caps universe with its potential for ‘double alpha’: benefitting from the inherent potential of small caps to outperform large caps (alpha) and adding additional value through astute stock selection within this universe (second alpha).

In conclusion, small-cap stocks have historically outperformed large caps over the long term, offering the potential for enhanced returns. The current market conditions—characterised by attractive valuations and improving economic indicators—may provide a compelling entry point for investors familiar with the complexities of the small-cap landscape. We believe strong convictions and active management are essential in this endeavour. By leveraging expertise and conducting thorough research, investors can uncover mispriced assets and capitalise on the opportunities that small caps present. As always, a disciplined approach and careful analysis are crucial in harnessing the potential of small-cap stocks.

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