- Small-cap stocks are approximately 10% cheaper than their long-term average as of the end of September (on a trailing price-to-earnings basis) compared to their large-cap peers, which are at a 27% premium—an attractive price.1
- We seek to avoid overpaying for the securities in our small-cap portfolios; yet, our bias toward reasonably-priced, higher-quality companies has hurt our performance versus the benchmark recently.
Mega-cap stocks (those with market capitalizations of more than $200 billion) have dominated stock-market performance over the last several years, causing some investors to question the value of owning small-cap stocks.
Land of the Giants
The U.S. technology sector—which includes multinational giants such as Apple, Alphabet and Microsoft—makes up a historically large percentage of the cap weighted S&P 500 Index (a broad measure of U.S. stocks). The narrow leadership of these behemoths has put pressure on active management, leaving small-cap stocks out of favor. As a result, portfolios that haven’t held the biggest of the big names have generally lagged their respective benchmarks in recent years.
However, these large stocks also come with lofty valuations.
Small Companies, Small Prices
Valuation is a quantitative method of determining an asset’s fair value. The valuation differential between traditional small- and large-cap indexes is rather stark. Looking at trailing price-to-earnings ratios, investors are willing to pay $52.1 today for every $1 in earnings generated by the largest companies in the S&P 500 Index—but only $17.2 for every future dollar generated by companies in the Russell 2000 Index (which measures the U.S. small-cap market).
The decoupling in valuations accelerated (or was exacerbated) due to the market low in March 2020 as the coronavirus crisis began to unfold in the U.S. During the rebound between March 23 and September 30, many small- and mid-cap indexes surpassed their large-cap peers; however, after the rebound, small-cap stocks remain approximately 10% cheaper than their long-term average. This represents about a 16% to 31% discount to large-cap stocks.2 We view this as an attractive price at which to add small-cap stocks to a balanced portfolio.
An Active Opportunity
Small-cap stocks are in a less efficient part of the market than large caps, providing opportunities for active management and offering historically attractive investment returns. This can be seen in number of ways, including analyst coverage, long-term total returns, the potential for alpha generation by active managers and the results generated by factor-based investment strategies.
Consider that the average number of analysts covering large-cap stocks is more than twice the number covering small caps and approximately ten times the number covering micro-caps.3 Reduced coverage increases the opportunity to find diamonds in the rough. Data back to 1926 support the long-standing belief that small-cap companies offer better growth opportunities than larger companies, as seen in Exhibit 2 (download the full PDF for exhibits).
The relative inefficiency of the small-cap market is often considered beneficial, as compared to the highly-efficient large-cap market.
The performance of factor-based investment strategies presents further opportunities due to the relative inefficiency of the small-cap market versus large caps. Strategies that invest in stocks exhibiting characteristics such as value or momentum have often demonstrated greater success as market caps get smaller.
This leads to research-based conclusions about valuations, resulting in conscious views about which companies to hold or not hold at any time and giving active management the opportunity to shine. Many active investment managers take a disciplined approach to the security-selection process, analyzing each company’s fundamentals, which can have a wide range in quality and potential performance-changing catalysts.
Everything in its Own Time
Small-cap stocks tend to be sensitive to the success or decline in a local economy. We saw this in March, as small caps underperformed large caps amid the accelerating selloff. This was unsurprising, given small-cap stocks’ historical tendency to lag during market selloffs. However, small caps also have historically led other market segments during a longer-term recovery.
Small Today, Big Tomorrow?
Every investor wants to discover the next Netflix, Microsoft or Google—all of which started out as small companies. Many small-cap stocks are early-stage, innovative and cutting-edge companies that have the potential to grow at a faster pace than their already-large counterparts. For example, a mega-cap technology stock may require an additional $26 billion in revenue in order to register a 10% annualized increase in revenue. In comparison, a relatively large small-cap technology company may require only $100 to $150 million in additional revenue to grow by the same 10%.
Therefore, small caps can potentially generate above-market earnings growth rates relative to their large-cap peers. Small-cap companies also tend to have higher levels of insider ownership than larger companies, which incentivizes them to generate shareholder value.
Small-Cap Stocks Enjoy an Election
We generally discourage short-term trading. However, small-cap stocks have historically performed well after U.S. presidential elections (source: Bloomberg), thanks to the renewed focus that political campaigns tend to put on the domestic economy—where the success of smaller businesses plays a large role. Since 1980, the Russell 2000 Index has returned approximately 4.0% higher, on average, than the large-cap Russell 1000 Index in the year following a presidential election.4
Small Caps Have Their Challenges
Liquidity and economic factors may sometimes have an overbearing influence on the behavior of smaller, less-liquid companies. Small-cap stocks are not as insulated as their large-cap peers, as has been seen during the COVID-19 pandemic. While some smaller companies may adapt and thrive, others won’t. Identifying and backing such companies can be a challenge.
Our small-cap strategies are actively managed. One-third of the companies in the Russell 2000 Index have no earnings, and we intentionally avoid investing in most of them. Instead, we seek to invest in profitable firms with solid earnings, good cash flow and below-average debt levels.
We also realize that a small number of high-priced software and biotechnology companies have an outsized influence on performance. We seek to avoid overpaying for the securities in our portfolios; yet, our bias toward reasonably-priced, higher-quality companies has hurt our performance versus the benchmark recently. Nevertheless, we do not plan to alter our investment process. Paying too much for companies that offer too little does not align with our investment philosophy.
At SEI, fundamentals matter. Over time, we believe that earnings multiples will return to their historical averages, and we expect the financial market to once again punish complacency and reward active stock selection.
We also believe that more diversification is better than less, that markets may (and do) behave in unpredictable ways, and that chasing performance is not a sound investment strategy.
1As measured by the Russell 1000 Index (large caps) and Russell 2000 Index (small caps) over the period 1/1/2000-9/30/2020.
2Source: SEI, Russell, Factset universe as of October 2020. Valuation discount metrics determined by fundamental characteristics provided by FTSE and include: price/book, dividend yield, price/earnings ex-negative earnings, EPS growth and number of holdings.
3Source: Factset as of September 2020
4Data as of January 1, 2018.
The information contained herein is for general and educational information purposes only and is not intended to constitute legal, tax, accounting, securities, research or investment advice regarding the Strategies or any security in particular, nor an opinion regarding the appropriateness of any investment. This information should not be construed as a recommendation to purchase or sell a security, derivative or futures contract. You should not act or rely on the information contained herein without obtaining specific legal, tax, accounting and investment advice from an investment professional. This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. There is no assurance as of the date of this material that the securities mentioned remain in or out of the SEI Strategies. Positioning and holdings are subject to change. All information as of November 12, 2020
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