Navigating Small Caps: The Importance of Sidestepping Low Quality

Over the past decade, U.S. small-cap stocks have trailed behind large-cap stocks by 5.1% on an annualized basis. This underperformance, alongside higher valuation multiples for large caps, leaves small caps looking relatively attractive on valuation. Some investors see this as an opportunity to buy small caps, while others are wary due to structural issues that are impacting fundamentals. We think small cap stocks require a more nuanced approach. Let’s take a closer look.

Comparing current valuation multiples to historical figures, and particularly to large caps, small cap stocks look attractive. In the past, favorable valuations have led to positive relative outcomes for small caps. However, to determine if small caps truly present a bargain now, or if the low multiples are justified, a deeper investigation is necessary. On average, small caps have generally become less profitable and taken on more debt. A significant portion of this debt carries a floating rate and is subject to refinancing at higher interest rates. Consequently, the overall quality of the small cap sector has diminished, evidenced by an increased number of companies with negative earnings or insufficient cash flow to cover their interest expenses. While this may seem concerning, it also presents a significant opportunity.

Low quality small cap stocks have reliably underperformed. For example, since 1984, companies with negative earnings have fallen short of the rest of the small cap market by 6.3% on an annual basis. And, they have done so with significantly higher risk. Although there are occasions when investors may prefer these speculative stocks, they have lagged 79% of the time on a three-year rolling basis. We believe investors should take this historical data into account when determining which stocks to hold or avoid in their small cap portfolios.

Regardless of whether small caps are expected to outperform large caps, they remain an important part of an equity portfolio. They offer diversification, especially in sectors like industrials, which may benefit from recalibration of supply chains and trade policies. While current small cap valuations look attractive, the prevailing “higher for longer” view of early 2024 likely tempers enthusiasm. Therefore, while investors may want to include small cap stocks in their portfolios, we suggest they do it selectively, steering clear of more speculative investments. Avoiding the speculative portion of the small cap market has served investors well over the long run and may continue to do so in the future.