US Small Caps: A smart move?

Small-capitalisation stocks are highly sensitive to business cycle fluctuations, facing challenges like tighter credit and higher labour costs, and while they underperform during downturns, they offer long-term growth potential. Does this make them a worthwhile investment in the current investment climate?

Small-cap stocks, as a distinct asset class, exhibit a high sensitivity to the fluctuations in the business cycle, responding emphatically to its various phases. This impact is evident in both downturns and upswings. In the throes of the 2020 pandemic, US small caps lagged their larger counterparts due to the plummeting economic activity. However, as vaccines became available in 2021, small caps began to close the gap with the S&P 500, anticipating a return to normal economic conditions. This scenario reversed when the Federal Reserve adopted a hawkish monetary policy to fight inflation, leading to a renewed underperformance against large caps. This shift subjected the asset class to several challenges, including tighter credit conditions, reduced credit availability, and higher labour costs. Subsequently, in 2023, small caps faced another period of underperformance, due to a regional banking crisis and concerns over the debt ceiling, impacting growth prospects and driving yields down.

Small caps face formidable challenges in both hard and soft-landing scenarios, given their weaker balance sheets and more volatile revenues, making them vulnerable to cyclical downturns. During such periods, preferring higher-quality investments is advisable. Historical analysis from a State Street study suggests that, on average, the optimal time to invest in small caps is approximately three to four months into a recession, holding these positions for one to three years. Small caps usually do well when inflation falls, and leading indicators reach their nadir, indicating an early cycle phase. However, current market conditions seem to reflect an end-of-cycle sentiment.

Valuation considerations further support the decision to invest in small caps. Many US small-cap companies are still proving their profitability. It is crucial to assess not only multiples like P/E and P/B but also a company's track record. While US large caps cannot be considered inexpensive today, the small caps' relative underperformance, a 20% drop since its peak, already incorporates very low PMI new orders. In a historical context, relative valuations look attractive, and absolute valuations are nearing levels seen in previous recessions. Since June 2022, the Russell 2000 has been confined to a 1600-2000 trading range. Presently, it hovers near the upper limit, driven by a recent decrease in long-term interest rates, but lacks a compelling catalyst for a breakout.

In the long term, smaller companies outperform — but beware of volatility

Source: Stockhead, State Street, 2023

At DPAM, a soft landing is considered the base scenario for the US. However, even in this scenario, US small caps face risks if interest rates stay high. Goldman Sachs analysts point out that nearly one third of these companies' debt is floating rate, implying that higher rates could harm small caps' weaker margins and overall performance. US small caps are overrepresented in cyclical sectors, especially within financials, where a substantial portion is in Regional Banks. Notably, the largest weight in US small caps is in the defensive health care sector, but there is also considerable exposure to the risk-on segment of healthcare, namely biotech. Valuation opportunities arise in industrials and information technology.

Despite short-term challenges, US small caps remain an attractive asset class over the long term, offering superior earnings per share (EPS) growth compared to large caps, historically leading to their outperformance. However, a clear understanding of the current phase of the economic cycle is crucial. Given the favourable valuation, gradually building up positions is recommended, anticipating a quick recovery once the right market signals appear.