Should you invest in small-caps during a US recession?

Should you invest in small-caps during a US recession?

FE Trustnet speaks to analysts about whether small-caps are the right place to be invested if an economic downturn in the US emerges.

Post By Henry Scroggs

By Henry Scroggs,
Reporter, FE Trustnet

US small-caps on average slightly underperform large and mid-caps during a recession but do much better off the back of it, according to research by FE Trustnet.

However, analysts said that not all recessions are equal and investors need to keep a keen eye on the nature of the next potential crisis when deciding where to put their capital.

In this study, FE Trustnet considered the last three big US recessions – the 1990 recession, the dotcom bubble of the early 2000s and the global financial crisis – and compared the small-, mid- and large-cap indices in the US – Russell 2000, Russell 1000 and S&P 500 respectively – to see how well they fared.

We took the trough of each index and paired this with how well they performed one year on from the trough.

The results showed that across three most-recent recessions, the average performance of the Russell 2000 index one year after its trough was a 49.11 percentage point increase, while the Russell 1000 was up 30.21 percentage points and the S&P 500 28.40 percentage points.

Performance of indices in 1990 recession

 

Source: FE Analytics

AJ Bell investment director Russ Mould was not surprised by these results and said that as investor risk appetite returns following a down market, money will move back into small-caps where the risks might be higher but so are the potential rewards.

He said: “Elephants don’t gallop and during an upturn small-caps are likely to provide greater gearing into the recovery and faster profits growth than more mature mid and large-caps.”

Whitechurch Securities head of research Jonathan Moyes added: “Coming out of a recession, smaller companies are at an incredible advantage to their unlisted peers due to their access to capital markets.

“Small- and mid-caps are able to take advantage of distressed asset sales in their domestic market, and alter their business models to a far greater extent than larger multinational businesses.

“What many clients may find remarkable is just how quickly those heavy losses have historically been recovered by markets, a great lesson in patient investing.”

Looking further to the future, AJ Bell’s Mould said that in the long term, there is a case for investing in small-caps because they offer greater profit and dividend growth potential than mid- and large-caps, not least because they are starting from a lower base.

He warned: “The emphasis must be placed on the words ‘long-term.’ Small caps still provide some sharp downdrafts during bear markets or recessions, so they cannot be described as ‘recession-proof’.”

Indeed, during the troughs of each recession the small-cap index fell, on average, by 3-4 per cent more than their mid- and large-cap counterparts.

Mould said that these findings also did not surprise him and that, relative to small-, mid- and large-caps will attract more investor flows during downturns because they are seen as a safer option.

“You would expect mid and large-caps to be better financed, have a wider range of products and services, customers and geographic reach,” he said.

“All of these features should mean they are better able to withstand any downturn, at home or overseas, than small-caps, which tend to be more dependent on key products, services, customers (and even executives) and can be less well-financed, as they are in an earlier stage of their development cycle.”

Performance of indices in dotcom bubble recession

 

Source: FE Analytics

However, senior investment manager at Premier Asset Management Simon Evan-Cook disagrees with this widespread assumption that small-caps are “riskier” than large-caps.

“Firstly, I think people assume that, just because a small-cap company is likely to be more risky than a large-cap company, that this means that small-caps, as a group, are riskier than large-caps,” he said.

“This isn’t true, for the same reason that if I had to back a mosquito or a mammoth in a straight fight, I’d back the mammoth every time. Yet at a species level, mosquitoes have evidently proved a lot less ‘risky’ than mammoths.”

Evan-Cook thinks that valuations are actually more of a deciding factor on how well the different caps will perform in a bear market and that ignoring valuations is the riskiest thing, not whether you’re invested in small- or large-caps.

“In terms of how they perform in a bear market, a lot depends on what was driving the preceding bull market,” he explained. “If it was a bull market where investors went crazy for small-caps, which happens from time to time, it’s likely that their valuations were more stretched, and they’d have had further to drop when recession induces a healthy dose of reality.

“But if, like in the late 1990s, the market has been driven higher by a lust for large-cap tech and an obsession with investing like an index (sound familiar?) then there’s a decent chance that the large-cap index can get whacked every bit as hard as the small-cap equivalent.”

Performance of indices in global financial crisis

 

Source: FE Analytics

Indeed, large-caps were hit equally hard in the global financial recession, said Ben Seager-Scott, chief investment strategist at wealth manager Tilney.

“Of course, each recession has its own characteristics, and the global financial crisis caused an especially deep and extended downturn, which is typical of recessions where the financial system is at the heart of the problem,” he said.

“This also means that large banks are often especially hard hit, leaving no hiding place in large-cap indices.”

Seager-Scott said it was worth pointing out that non-US small-caps such as those in the UK did behave more typically and lost 61 per cent compared large-caps which lost 48 per cent.

The dotcom bubble also had its own characteristics and was driven by the large tech sector rather than a broad-based crash, he said.

“The result was a recession that was short, shallow and largely limited just to the US, as opposed to a global recession,” he said.

Overall, Seager-Scott said that the data is useful in highlighting that not all recessions are equal and you can’t just assume that large-caps will provide safety relative to small or mid-caps.

Add your comments

Theo

As usual your gurus have managed to confuse everybody by complicating what is very simple and clear. -/------/- In a market crush the smaller companies in aggregate fall more than the larger ones, but rise more from the bottom afterwards as confidence returns. This makes smaller companies higher risk and their behaviour is in line with the risk/reward law of investing.

BJ22

During the last big crash (2008) the best funds to hold (apart from some TAR funds) were Global Healthcare, eg. L&G Global Healthcare Index (+8% in 2008). Global Resources funds also fared better than most. Will history repeat itself?? ANY OPINIONS OR OTHER SUGGESTIONS?

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