Small-cap stocks have been underperforming larger ones for the second longest stretch since the 1930s. But there are signals that small-cap stocks may be coming out of their dark stretch.
As outlined in a report by advisor Pinnacle Associates, the widening gap began in December 2016. In the subsequent seven years ending November 30, 2023, small caps returned 46.25 percent, compared to the S&P 500 generating returns nearly triple that mark at 130.9 percent.
Small-cap stocks are historically cheap. According to a recent Wall Street Journal article quoted in the report, the forward price-to-earnings ratio for the S&P Small Cap 600 is 13x, as compared to 19x for the S&P 500 and 32x for the Magnificent 7. “The forward P/E of the small cap Russell 2000 is closer to 15x, according to Jefferies, near the low end of its historical average,” wrote the report’s authors. “The last time the index traded at this level was over a decade ago in December 2012. The Russell 2000’s relative P/E trades at a 21 percent discount to large caps, last seen back in April 2001 and nearly 25 percent below its long-term average.”
A key reason for this is that small caps have struggled in the high interest rate environment more than large companies. Small caps tend to be more focused domestically with earnings growth often closely tied to how the U.S. economy is performing or sentiment about how the economy will perform.
In addition, small companies depend more on floating-rate debt, whose payments rise in tandem with interest rates, and bank financing. Larger companies can borrow money at lower rates by issuing bonds. According to Goldman Sachs, 30 percent of Russell 2000 company debt is floating rate as opposed to 6 percent for S&P 500 company debt.
The decline in the overall level of M&A activity is also a contributing factor. According to Bloomberg, Global M&A deals announced in the third quarter of 2023 totaled just $641 billion, which was the lowest third-quarter since 2013. The report also notes that the first quarter of 2023 saw deal value sink to its lowest point in two decades. Historically, M&A activity has been a source of upside in the small cap space over the long term.
Pinnacle makes the case that the current conditions are encouraging for small caps to close these performance gaps. Jefferies analyzed seven similar periods of significant underperformance of small vs. large stocks. On average, after these difficult periods, small caps outperformed large caps by 22.2 percent, 10.5 percent, and 9.8 percent annually over the subsequent 1, 3, and 5-year periods, respectively.
In the past, small caps often begin outperforming as the market begins anticipating Fed rate cuts. According to Morningstar, the Russell 2000 has risen an annualized 25.2 percent during periods of increasing growth and slowing inflation since the 1970s, outpacing the S&P’s 17.3 percent annualized gain in such environments.
“With valuations at historical lows on relative and absolute terms, and numerous beneficial catalysts on the horizon, the opportunity set appears to be very constructive.”
