Throughout history, small-cap equities have been a hedge against inflation, displaying a remarkable trend of consistent outperformance every decade since the 1930s. Despite this impressive track record, large-cap stocks have more recently overshadowed small-cap stocks.
Since the dot-com bubble, there has been a significant divergence between large-cap and small-cap companies. The relative comparison of valuations between the two types has not reached levels seen since that period. During that time, small-cap start-ups were the focus of attention, but the market eventually shifted towards larger, more established companies due to their quality and stability, and the preferred approach is to invest in large-caps passively. Small-caps are, however, gaining favour with the current market conditions, reversing their previously overlooked trend.
Over the past 15 years, small-cap companies have undergone a significant transformation, no longer simply nascent start-ups but established entities boasting market capitalisations ranging from $500m to $7bn. They’re still relatively small compared to US large-caps such as Apple or Microsoft, achieving ‘mega-cap’ status with a combined market capitalisation that exceeds the Russell 2000 index by almost $2trn. However, small-caps offer investors an opportunity to capitalize on the value-oriented nature of the Russell indices in contrast to the S&P 500.
Source: Strategas, Nov 2022
Amid the current inflationary, lower-growth climate, investors seek exposure to undervalued companies with high growth potential. Small-cap stocks are particularly attractive because they are some of the most innovative, entrepreneurial, and disruptive growth companies that take market share from their competitors due to their relatively modest size and ability to proliferate.
The market has many high quality small-cap companies that can achieve organic growth rates of 10% or more annually – a formidable feat for most large-cap firms like Apple. Consequently, they acquire these burgeoning small-cap firms, which have become an attractive option for investors seeking to maximize returns.
Additionally, small-cap companies possess a unique ability to adapt and prosper amidst fluctuating market conditions. Small-caps benefit from greater exposure and opportunity in the US than their international counterparts, which can be more prone to market volatility.
They can be more vulnerable during market downturns but have emerged as leaders over the past six recessions. They’ve also yielded better than just about any other part of the equity spectrum with a good performance track record over the long term.
Source: Strategas, Nov 2022
Investing in small-cap assets when things turn around is crucial and can be a much more efficient space relative to large-caps. The main challenge is market timing because missing out on a substantial part of the return means being on the side lines when the market turns, which is the more significant risk.
Three to four sectors comprise the lion's share of small-caps: technology, healthcare, consumer discretionary, and industrials. Historically, the fourth largest has been financials, but it has been shrinking. Technology, healthcare, and consumer discretionary are the three most significant sectors, and at the moment, investors are overweight in all three industries, which means they're seeing significant growth opportunities.
Source: Strategas, Nov 2022
Small-cap stocks are a dynamic yet risky investment space relative to large caps, but the potential rewards are too good to ignore. They have a historical track record of generating solid returns during inflationary periods and, when emerging from recessions, offer impressive returns over the long run.
By identifying the most promising, actively managed small-cap companies, investors can tap into exciting growth potential that outstrips the opportunities provided by their larger-cap counterparts.
Don Klotter is CEO of EFG Asset Management. The views expressed above should not be taken as investment advice.