Nick Ford
Premier Miton US Smaller Companies Fund manager
For information purposes only. The views and opinions expressed here are those of the author at the time of writing and can change; they may not represent the views of Premier Miton and should not be taken as statements of fact, nor should they be relied upon for making investment decisions.
Small cap syndrome?
The vastly superior returns of large cap stocks over small in recent years might prompt investors to question “why do people bother with small caps?”. The appeal of the US small cap sector stems from its abundance of fast-growing companies capable of delivering more rapid share price appreciation. This is area of the market where investors are prepared to take more risk (returns can be volatile) in the hope of greater longer-term rewards.
Diminishing economic headwinds
However, two major headwinds, higher interest rates and fears of a recession, appear to have diminished investors’ appetites for US smaller companies. The share prices of innovative and disruptive businesses, offering the promise of vast profit potential in the future, have been significantly marked down as the Federal Reserve made it more expensive to borrow money.
A higher interest rate means a greater discount is used by analysts when calculating the value of expected profits in the coming years and this results in lower valuations. Worries about growing risks of an economic downturn have prompted many investors to increase their exposure to larger companies which can raise capital or issue debt more easily than their small cap counterparts. Companies in the S&P 500 Index have more diversified revenue streams as well as greater geographic diversification making their earnings more resilient when economies contract.
Taking a breath or getting ready to take off?
We think the move out of small caps may be close to having run its course with several factors making this an excellent time to revisit an out of favour sector. First, valuations are near twenty-year lows as shown by the chart below: the risk that the profits of smaller companies may fall if there is a recession may already be priced in.
S&P 600 Small Cap PE Ratio vs S&P 500 PE Ratio
Source: Bloomberg, William Blair Equity Research data from 01.12.1992 to 30.09.2023. Past performance is not a reliable indicator of future returns. Bear markets are shown by the grey shaded areas.
Second, and counterintuitively, the best time to own smaller companies is coming out of a recession. This is because investors have already cut their holdings (depressing valuations as noted above) in anticipation of one. As economic activity stabilises and begins to accelerate, a typically domestically focused smaller company may experience a more powerful profits surge compared to a mega cap multinational organisation which may not be experiencing similar dynamics in its many overseas markets.
As investors notice that analysts are raising earnings forecasts for smaller companies to a far greater degree than for large companies, there is renewed interest in the sector. Furthermore, the relative lack of small cap trading liquidity can produce outsized share price gains as traders may be forced to raise bids to generate sufficient volume to meet demand from active fund managers. The Russell 2000 Index may significantly outperform the S&P 500 Index during this period which can last several years or more.
Taking the pulse on small caps
Within the small cap universe, the Healthcare and Technology sectors feature some of the most innovative and fast-growing companies. Technology is a key part enabling enterprises to do more with less and Artificial Intelligence (AI) is now starting to be widely adopted by software engineers. We are already seeing a surge in investment in data centres to power AI and demand for the high-performance microchips which power them and many smaller capitalised semiconductor companies should benefit from this trend.
In Healthcare, a vast number of innovative medical device manufacturers have developed revolutionary techniques to treat cardiovascular diseases and enhance surgical procedures. Sales growth is now accelerating in the aftermath of a recovery in procedures cancelled during the pandemic.
Elsewhere, geopolitical events should benefit domestically focused companies in the Industrials sector. The global pandemic, the impact of the war in Ukraine and now trading restrictions with China have exposed the downside of the multi-decade trend to outsourcing the manufacturing of key components including semiconductors and related technology hardware. The resulting severe supply chain disruptions experienced over the last two years is driving a reversal of this approach – a move to “re-shoring.” We are consequently seeing a US manufacturing renaissance as corporations re-establish domestic production capabilities. Again, the prime beneficiaries will be the smaller US companies that help build the new factories, pave the new roads to connect them to highways and supply the components, machinery, electricity and plumbing to get everything up and running.
So not only does the small cap asset class have valuation/timing in its favour, but also the fundamentals for three key sectors within the Russell 2000 Index look extremely positive.
