2016 has so far been a rather traumatic year for US investors. By the middle of February, worries about a slowdown in the Chinese economy, collapsing oil prices and some weak US economic data and corporate earnings had caused the S&P 500 Index to fall more than 10 per cent from the beginning of the year. 
The Russell 2000 Index of smaller companies fared even worse with a fall of 16 per cent. But since then, the investment backdrop appears to have improved: talks of production freezes from Saudi Arabia and Russia stabilised oil prices and comments from the Federal Reserve (suggesting that interest rate rises were likely to be extremely gradual) reassured investors.
By the end of March the market had recouped all its losses following some better economic data – in particular evidence of further robust US job creation.
Performance of indices in Q1 2016
Source: FE Analytics
Smaller companies, as measured by the Russell 2000 Index, did not participate as fully in the rally, trailing the large cap S&P 500 Index by 2.7 per cent in the first quarter of 2016.
Over a longer time period the performance of small caps compared to large is even worse. Small caps are an astonishing 14 per cent behind large caps over the last two years. Why is the sector doing so poorly?
There are several reasons. First, investors usually prefer to invest in small caps early in the life of an economic cycle when it is assumed that growth will be plentiful for many years to come – a factor which encourages risk taking (small caps often have less diverse revenue streams which can result in greater earnings volatility).
Performance of indices over 2yrs
Source: FE Analytics
The US economy has now been recovering for seven years since the downturn of 2008-9; an unusually long period before a downturn by historic standards. As investors begin to anticipate that a downturn might not be far away, risk appetites fade and the safety of larger cap stocks is preferred.
Second, in recent years asset allocators have been increasing their exposure to US equities now that the dollar has regained its status as a strong currency. S&P 500 Index funds have been a major beneficiary.
However, small caps are usually overlooked when there are these types of move because their more limited trading liquidity makes their shares more awkward to buy. Furthermore, the “narrow” market of 2015 amplified the small cap underperformance: the average stock in the S&P 500 trailed the overall return of the index as a result of the strong performance of a select number of mega caps – in particular the so-called ‘FANGs’ (FaceBook, Amazon, Netflix and Google).
As the “FANGs” began to rise sharply, their collectively large weight in the index meant that active managers benchmarked against the S&P 500 who did not hold these stocks were more likely to underperform.
Many investors would have elected to reduce any sizeable off index bets (including small caps) in order to free up cash to get up to weight in “FANG” names and stop haemorrhaging performance.
The final factor behind the disappointing returns of small caps relative to large is valuation.
Small caps have traded at a 20 per cent price to earnings multiple premium to large on average over the last twenty years but enthusiasm for the sector became excessive from 2010 onwards and the premium exceeded 45 per cent - virtually a record high over the period. Since the sector started to underperform from March 2014 onward the premium has shrunk back down to just above the long term average.
Unfortunately, when small caps really fall from favour the premium can shrink to a discount – so there might be further potential risk.
Assuming this is a traditional economic cycle with a downturn approaching, the current outperformance of blue chip stocks over small caps makes sense. However, if investors start to believe that the US economy can grow for far longer (an elongated cycle) but at a more modest pace, the stronger earnings growth that small caps can deliver will start to look appealing again and the poor returns of the Russell 2000 may be near an end.
The CF Miton US Opportunities fund that I manage with Hugh Grieves has a flexible mandate that allows to invest across the market cap spectrum, from the very largest companies through to medium and small size stocks.
Performance of fund versus sector and index since launch
Source: FE Analytics
From this we will select what we consider the very best ideas for the fund regardless of its market cap size.
Our exposure to smaller companies has been modest over the last year because the generally high valuations of the sector prevented most of the companies we were interested in from fitting our investment process.
Our best ideas have been mainly larger companies – in particular those where activist shareholder pressure has forced management teams to improve returns on capital. Restaurant operator McDonalds and soft drinks company Coca-Cola are good examples.
However, if it becomes clear that there will be no downturn in the US economy for the foreseeable future, we might be on the cusp of another period of small cap outperformance. Bottom-up stock pickers with the flexibility to look at this area of the market should be in a position to take advantage of the superior returns that small caps can deliver.
So, with the Russell 2000 now looking more attractively valued than it has been for a while, it might be time to think about increasing exposure to small caps again.
Nick Ford is co-manager of the CF Miton US Opportunities fund. All the views expressed above are his own and shouldn’t be taken as investment advice.
