Quality investing is an approach well suited to small cap equity. As an asset class, small cap has become notably cheap this year. GMO recently launched a Small Cap Quality Strategy to take advantage of the alignment of attractive long-term small cap quality stock characteristics and compelling short-term valuations. We believe this new Strategy is well positioned to outperform, while offering defensive characteristics especially valuable for investors searching for opportunity in an uncertain market environment.
We believe a moment has arrived when long-term and short-term opportunities in quality small cap equity are finally aligned, when one can invest in high-quality small cap names at attractive valuations. At a time of heightened uncertainty for many risk assets, investors can confidently add small cap quality to their equity portfolios.
The Small Cap Quality Opportunity
ATTRACTIVE VALUATIONS TODAY IN SMALL CAP
For most of the past decade, small cap stocks were expensive versus both their own history and their typical multiples against large cap stocks. However, in more recent years, there has been a significant derating of small cap stock valuations, which have fallen 39% from their post-Global Financial Crisis peak versus the broader market. 1 Today, we believe small cap stocks have become notably cheap. Within the U.S., small caps trade at an 18% discount versus their typical relative multiple against the total market.
EXHIBIT 1: SMALL CAP RELATIVE VALUATIONS HAVE BECOME ATTRACTIVE
U.S. Small vs. U.S.: Normalized Earnings
Data from December 1976 through September 2022 | Source: Worldscope, GMO
Small cap’s decline in valuation has been driven in part by fears of an economic slowdown. We believe this presents a compelling investment opportunity in quality: small cap quality offers a way to take advantage of attractive small cap valuations while reducing downside risk. Indeed, GMO’s Asset Allocation team recently began allocating capital to U.S. small cap quality in select portfolios.