Taking a long view on small caps

In fact, it is the narrowest leadership in a rising market since the 1990s.

As the Q1 earnings season unfolds, many of the largest tech companies are delivering positive earnings surprises.

A focus on efficiency, alongside positive narratives on the outlook for the technology sector – such as the prospect for lower interest rates, growth of cloud and generative artificial intelligence – has spurred investor sentiment.

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So far, almost half of US and one-third of European companies have reported. Earnings growth is largely coming in better than expectations both in terms of magnitude and breadth.

Economic growth and consumer spending have been more resilient than feared in the face of recession worries. However, with central banks likely to keep rates higher for longer to tame persistent inflation, growth is projected to slow in the second half of the year, alongside earnings, as the lagged effect of tightening starts to bite.

Furthermore, it is worth noting that earnings projections were meaningfully downgraded coming into the quarter, so the bar to beat has been lowered.

Forward-looking valuation metrics for mega-cap tech stocks remain stretched, with the sector seemingly over discounting the prospect of rate cuts and leadership turning more defensive. The strong performance of the S&P 500 so far this year may be a sign that investors are crowding into companies they think can be the most resilient in a slowing economy.

Not all growth is equal, however, and investors should be mindful of starting valuations and focus on durable quality growth.

Compelling valuation discount 

Smaller-cap stocks on the other hand, have been shunned – weighed down by turmoil in regional banks (which are well-represented in the mid and small-cap indices) and are largely pricing in an anticipated recession and tightening of financial conditions.

Unsurprisingly, riskier assets have suffered more in an uncertain landscape. However, if you are willing to lean against the wind and take a longer-term perspective, now could be a time to lean into small caps as they look remarkably cheap.

Valuations have rarely been more compelling, having fallen to two-decade lows relative to larger companies (last two times were 1999/2000 and 1973, notably also periods of regime change).

History shows that when smaller-cap valuations have reached similar extreme levels, they have subsequently gone on to lead market recoveries following periods of economic turbulence – outperforming large-caps over multiple years.

Current price to earning multiples are pricing in a sharp decline in earnings – like that seen in the aftermath of the Global Financial Crisis, as such we have seen significant multiple compression. Earnings have however, been generally good – perhaps better than many feared.

Nimble during regime change

Small-cap companies are vulnerable to volatility, with their stock prices and earnings getting hit particularly hard in economic downturns.

However, they have historically recorded some of their best performance relative to large-caps, coming out of a slowdown and leading into recovery. The Russell 2500 beat the S&P 500 by an average of 14.7% in years following bear market bottoms. And, as economic regimes change, typically so does market leadership.

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Following the dotcom bust, and the implosion of the top five S&P 500 leaders, the Russell 2500 went on to outperform the S&P 500 for nine of the next ten years. 

Being small has its merits, companies can be nimbler and adapt, they also have greater scope to grow earnings more rapidly.

Those in more niche industries can also command greater pricing power and better protect margins.

Onshoring beneficiaries 

With geopolitical risks elevated and the move towards localisation, more domestically orientated smaller companies stand to benefit. This is particularly true in the US, where onshoring is a key priority in the wake of supply chain disruptions.

Legislation such as the Infrastructure Investment and Jobs Act, CHIPS and Inflation Reduction Act have been introduced to incentivise domestic manufacturing and investment.

Some companies already note the positive impacts of these initiatives. While we might have expected benefits to be evident from 2024 and beyond, seeing this show up now is encouraging and will continue to play out over many years.

Sorting the wheat from the chaff

Smaller companies constitute approximately 20% of global markets by market cap, but around 70% by the number of companies. They provide a large breadth of opportunity for investors to diversify.

While smaller cap stocks more broadly may continue to be challenged near-term – select companies show relative strength, and deep fundamental analysis can be fruitful to uncover gems flying under the radar.

Stock picking matters though. The Russell 2000, for example, has approximately 40% non-earners, and companies with business models that fail to earn a reasonable return that may struggle amid an economic slowdown and tighter lending environment.

A focus on quality companies with good business models, strong balance sheets and lower leverage can prove its worth in times like this.

The fear of recession is reflected in valuations, and we are seeing good opportunities to invest in companies that already discount a very onerous outlook. 

While the road ahead is likely to be bumpy, it could be a good time to think about adding some small-cap exposure, given the valuation cushion of companies trading below their long-term potential.

Market timing is difficult though and missing out on the ‘best’ days can significantly dent annualised returns. While it may not pay off in the next quarter, it is an area that we expect to generate returns for years to come.

History tells us that recoveries following bear markets are enjoyed most by those who have the patience and discipline to take a long-term perspective. This is an asset class that warrants a long-term, strategic allocation if an investor wants to reap the full rewards.

Ritu Vohora is investment specialist, capital markets, at T. Rowe Price