The Stage is Being Set for Small Cap Equities

U.S. small-cap companies (market capitalization between $900 million and $6 billion) have underperformed their U.S. large-cap (market capitalization above $16 billion) counterparts over the last few years, but we believe there are a few key reasons why the stage is being set for small caps to play some catch-up.

1) Valuations for small-cap equities are historically cheap compared to large-cap. The chart below shows 5 common valuation metrics and the relative premium/discount for small-cap (S&P 600) vs large-cap (S&P 500). When the lines are above 0% it suggests that small-cap stocks are trading at a premium valuation, and conversely, when the lines are below 0% it suggests that small caps are trading at a discounted valuation. Small caps have not seen these discounted valuations in over 20 years.

2) Investing purely based on valuations can leave investors subject to value traps. However, analysts expect earnings for small-cap companies to outpace both large and mid-size firms as shown below. Admittedly, small caps have had their 2024 earnings expectations revised lower throughout the year. Investors are likely in “wait and see” mode for these earnings forecasts, but given the significant valuation discount, if earnings come in anywhere near their projections for 2025, we believe it would be a very positive catalyst for small caps.

3) Small caps tend to outperform large caps following the first rate cut by the Federal Reserve. On September 18, 2024, the Federal Reserve announced its first interest rate cut in more than 4 years of 0.50%. The chart below considers all the times (back to 1974) that the Fed initiated the first cut and compares the performance of small caps relative to large caps, looking at performance before and after that first rate cut. The bars above 0% indicate small cap average relative outperformance, which is shown in the 6 and 12 months following the Fed’s initial cut.

In addition, there may be fundamental reasons to support this. Part of the reason for the small-cap underperformance has been the Fed’s aggressive hiking of interest rates over the last couple of years. The Fed increased the Federal Funds Rate from a range of 0% – 0.25% up to a range of 5.25% - 5.50% throughout 2022 and 2023. The reason it affected smaller companies more than large ones is that small-cap companies have more short-term and floating-rate debt, whereas large-cap companies were able to lock in more of their fixed-rate debt at lower rates. The chart below highlights this fact when comparing two small-cap indices (S&P 600 & Russell 2000) to the S&P 500.

As interest rates moved higher in previous years, the cost of debt for small caps rose higher than for large caps affecting their profitability. Thus, if the Fed is embarking on a cutting cycle to bring rates lower as currently expected by the market, small-cap companies should start to see their cost of debt come back down, helping to improve profitability.

US economic growth is slowing, but we believe small caps have already priced in a lot of the expected slowdown. If the economy continues to avoid a recession and achieve a “soft landing”, these fundamental tailwinds for small caps may finally take shape leading to a catch-up rally. Thus, we believe broadening out US equity exposures to include a tilt toward small-cap exposures to be prudent.