Small Caps, Big Potential

Below is a transcript of this week’s video.

Hi, this is Mike Reynolds with Investment Strategy at Glenmede.

U.S. small caps are looking like an increasingly attractive investment opportunity for multiple reasons. First of all, although U.S. large cap stocks have soared to record highs amid the latest market rally, small caps haven’t quite kept pace yet. In fact, the Russell 2000 index remains about 15% below its all-time high set in 2021. The result is that their valuations actually appear quite fair at this point. Also, as the possibility of a soft landing appears increasingly viable, small caps may be poised to outperform as they catch up amid an improving economy. Small caps tend to be more economically sensitive than their larger counterparts, underperforming during recessions but posting better results when the economy is humming along. 

Those fair valuations on small caps stand in stark contrast with their large counterparts, which have been driven by richly valued growth stocks caught up in the fervor over the Magnificent 7. That divergence is currently at a historical extreme. The difference in valuations between large and small caps now sits at the 93rd percentile, eclipsed only by the mania seen during the peak of the Tech Bubble in the late 1990s.

Of course, past performance is not always a good indicator of future results, but the last 10-years have been a tough one for small caps. Large caps have outperformed by more than 5% per year, on average, over the last 10-years, which seems like a lot but is not totally unprecedented. What’s important though is how small caps typically behave after these extremes. Historically, small caps have flipped the script afterward, outperforming by 4% in the next year, on average.

The fundamental backdrop for small caps might also be poised for improvement this year. 2023 was a tough one for the asset class, which saw its earnings drop by about 10%. But with that behind it, 2024 is looking more auspicious, with bottom-up analyst consensus calling for almost 20% growth in earnings per share this year, well outpacing both foreign and domestic peers. 

So to summarize, small caps have historically done worst during recessions, but as the odds of soft landing continue to rise, that risk may be receding now. While the equity market has broadly looked pretty expensive, underneath the surface there’s a good amount of dispersion, with small caps at their largest valuation discount relative to large caps since the Tech Bubble. If history is any guide, the recent run of underperformance for small caps might be setting up for greener pastures ahead. And finally, earnings growth is projected to rebound for small cap this year after a disappointing 2023. Altogether, the combined tailwinds of falling recession odds, favorable valuations and strong earnings growth expectations should warrant tilting equity portfolios in favor of small caps.

Thanks for listening! And please don’t hesitate to reach out with any questions.