Declaring the demise of an asset class is a mistake people have made since the dawn of markets. It’s a temptation many on Wall Street succumbed to recently when small-cap stocks notched two-decade lows versus the S&P 500 – only to rally sharply after the Federal Reserve’s dovish policy surprise last week.
Yet for all the short-term market noise, existential fears surrounding the investing style are long standing and profound. Since markets soured at the start of 2022, the Russell 2000 is still down roughly 12%, while the S&P 500 and Nasdaq 100 have more or less recouped their losses.
Thanks to deep economic changes, smaller firms overall are less profitable, less exciting and more indebted — disadvantages they will struggle to overcome over the long run, skeptics warn. As private markets boom, the likes of Verdad Advisors see an industry increasingly starved of high-quality younger companies, while loss makers get listed and profitable darlings exit.
All that emboldened a Furey Research Partners strategist to sum up the threat to the asset class in blunt terms in a recent note: “It is time to face the facts — the “Death of Small Cap Equities” is upon us.”
“All of us here are tired of writing the essay that says ‘here’s why small-cap is going to work,’” said Jeff Burton, co-founder of small-caps specialist Furey, who says he penned the note with a whiff of melodrama in mind. “Our clients are well aware of some of the problems. They hear it from investors all the time.”
He still sees a resurgence for the cohort fueled by wide valuation discounts. Yet Burton understands the challenges that have spurred investor apathy. At the center of the concern is evidence of impaired profitability that some worry has become a permanent feature of the market landscape. According to Verdad, the median American small cap in 1995 posted gross profits of about 29% over assets. Now it’s just 14% — even excluding health care, with its share of profitless biotech and pharma stocks.
The contrast in balance sheets among big and small businesses has also become stark. Over the past two decades, the largest US companies doubled their earnings relative to interest payments, Societe Generale SA data show. That fortified them against the impact of rising interest rates. Small caps are nowhere near matching the feat.
Stranger still, this deterioration has been mostly an American phenomenon; in Japan and Europe, little has changed, according to Verdad.
“We see secular reasons why it won’t re-rate back to those high levels,” said Thushka Maharaj, a multi-asset strategist at JPMorgan Asset Management, referring to the long-term outlook for US small-caps. “It’s more profitable companies staying private because they have financing privately, but also large established companies growing their revenue because of this concentration in new innovative technology.”
Views like these are a warning to value hunters heartened by the recent green shoots in the Russell 2000 on signs the Fed is closer to easing monetary policy.
Problems for the investing style run beyond the near-term monetary outlook. And the theme of big-beating-little runs deep. Even among large caps, the concentration of gains in artificial-intelligence champions has meant that only about a quarter of S&P 500 members matched or exceeded the index’s 23% gain this year.
In a sign of mega-cap dominance, an equal-weighted version of the benchmark is set for its worst year versus the regular value-weighted one since 1998.
That’s giving succor to theories that American markets have been fundamentally transformed in the new age of tech and more than a decade of cheap money. Scalable software and networks are so winner-take-all that they favor the incumbent. And when that’s not the case, the new innovators are now remaining private for much longer thanks to the boom in private equity, the thinking goes.
Even excluding health care, US small-caps’ median gross profits over assets has dropped over the years. Source: Verdad Advisors
“We’re seeing a greater increase in the number of just unprofitable companies that enter the universe” of listed small-caps, said Chris Satterthwaite, an analyst at Verdad. “There’s definitely some truth to the fact that the most interesting and exciting and perhaps coveted private companies are staying private longer.”
When JPMorgan Asset’s multi-asset team recently examined the small-cap premium — the higher returns these stocks are meant to reap commensurate with their riskier nature — they cut their forecasts to the lowest in years, citing the change in sector mix and growth in private capital. These small companies were actually beating the large in terms of sales growth during the 2000s – a reflection of their youthful potential. Yet by the past decade these levels had converged, data compiled by JPMorgan Asset show.
In Verdad’s analysis too, listed companies both big and small have become less profitable over the past two decades, but the drop has been far steeper for the latter, driven by the worsening quality of new market debuts.
Among smaller American stocks, a growing percentage has been financial or biotech stocks, neither known for their stellar profits. Meanwhile, tech — the S&P 500’s superstar sector — has been contributing a falling portion to the profits of small caps overall.
All that has, in turn, widened the difference in leverage between the big and small. While US large-caps have mostly financed themselves with bonds with long duration and fixed interest rates, smaller firms are now facing more pressure from debt coming due and rates surging, according to SocGen.
Source: Societe Generale
“We’ve seen the largest technology companies particularly in the United States but globally become even larger, and part of that has to do with the abundance of capital that these companies could expand,” said Kent Chan, equity investment director at Capital Group, which runs a $71 billion global small-cap fund. “If you go back to 1999 to 2000, the exact same thing happened and then the cost of capital increased and you started to see smaller companies innovate outside large companies.”
Chan, Verdad’s Satterthwaite and Furey’s Burton are all quick to note these top-down observations belie a treasure trove of profitable gems at potentially dirt-cheap prices. That’s a silver lining to money managers: Worsening trends mean there’s a greater case for stock picking, at a time when the S&P 500 is looking exceedingly hard to beat.
The S&P SmallCap 600 Index, which already strips out profitless stocks, is trading near the lowest valuations ever versus the large-cap benchmark in data going back to 2005. In that lens, morbid references are only a sign that small caps have been unfairly maligned.
“When you get nominal growth decelerating you get interest rates coming down — that should be good for small-caps,” said Brad Neuman, director of market strategy at Alger. “It kinds of depends on whether it’s a soft or hard landing and how far nominal growth decelerates, but I think the valuation discounts are unsustainable.”
Capital Group’s Chan agrees the market looks oversold, though he also adds he’s finding better bargains among small firms outside the US.
Yet the concern now: As the best startups choose to stay private for longer, small-cap investors simply have a worse slate to choose from. That reflects a long-term trend. Except for a surge in 2021, the number of public debuts has dropped since the 1990s, and companies coming to stock exchanges are now typically more mature, data compiled by University of Florida economist Jay Ritter show.
The number of stocks in the US has fallen 45% since their 1997 peak, with the small-cap count down by 60%, according to the Center for Research in Security Prices.
So, is the asset class lifeless? Not exactly, according to Burton, who says he titled his note partly on the hope of marking a bottom.
“Some of these issues that are plaguing small cap are real, but our view is they’re largely discounted now,” he said. “If we got close to taking the curse off small-caps by writing the death of small-cap equities, so much the better.”
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