Could an opportunity be approaching in small caps?

After the gloom of 2022, 2023 has brought tentative reasons for optimism on the global economy. In particular, the weakening of inflationary pressures has fuelled hope that the recession may not be as severe as expected. Smaller companies have typically done well at times of improving economic sentiment. Following a tough year, is now the time to reconsider small cap shares?

Smaller companies constitute approximately 20% of global markets by market cap, but around 70% by the number of companies. Smaller companies also tend to be under-represented in institutional portfolios. This means there is a diverse opportunity set while smaller companies are a natural home for active management.

It is important to remember, smaller companies are risky. Over the longer term, they typically exhibit higher volatility than their larger peers. Equally, drawdowns will tend to be larger in small cap indices. We saw an extreme example of this in the UK during 2022, when the MSCI UK Small Cap Index experienced a peak-to-trough fall of 46%, while UK large caps, as measured by the MSCI UK Index, was down only 5% at its worst¹. That extra risk has, so far, been rewarded over the longer term. Even despite those falls last year, the MSCI UK Small Cap Index has delivered an annualised return of 10.8% versus 7.8% for the MSCI UK over the past 20 years².

This applies to most geographic regions, but the notable exception is the US where the Russell 2000 Index has underperformed the S&P 500. This is largely a recent phenomenon, and a by-product of the incredible performance from behemoth technology companies such as Amazon, Apple, Microsoft or Alphabet. Small cap performance has been strong, it has just lagged these mega-caps over the last market cycle.

Small companies may not get enough credit for the diversification they can bring to a portfolio. The correlation between small and large-cap equities tends to be around 70%. There are good reasons for this: both are equities and there is a tendency for the asset class to perform similarly, especially in times of stress. But there are also differences – large-cap companies tend to be driven by global macroeconomic forces, such as oil prices, economic growth or inflation. In contrast, small caps are driven by stock-specific factors, related to local markets or company management. More than 50% of small-cap fund variance is attributable to stock-specific factors compared to just 5% for large cap³. So, while they are not uncorrelated, small caps could offer attractive diversification to a predominantly large-cap equity portfolio, lowering the overall level of risk.

Intuitively, most investors recognise that there will be times when smaller companies will do well and times when they will struggle. Small caps tend to do best when the domestic economy is emerging from recession and growth is improving. Some of this cyclicality comes from the relative sector exposures of small cap versus large cap. Smaller companies tend to be exposed to more economically-sensitive areas such as real estate, materials and industrials, while being less exposed to defensive areas such as healthcare, consumer staples and energy.

Another notable element to small-cap performance is that it tends to bottom out while the economy is still in recession. The right time to invest often coincides with the worst economic news. After all, small caps are typically riskier than their larger-cap peers, and investors often want to avoid them when the outlook is most dire. Furthermore, because small-cap performance tends to be more closely related to their domestic economies, small cap outperformance is not usually perfectly synchronised on a global basis.  This can create opportunities for the nimble active manager.

It's also worth recognising that analyst coverage of smaller companies is far lower than those devoted to large-cap companies, where most of their client interest lies. With fewer people focused on the companies, their stories and fundamentals, the likelihood of the shares trading at the ‘wrong’ price (i.e. too cheap or, indeed, too expensive) is increased. Portfolio managers paying attention could have a better handle on the prospects for some of these names and therefore better identify value opportunities.

The data emerging from the ISM manufacturing and services surveys does not yet suggest an economic recovery - these have historically served as good proxies for business sentiment and can be used to gauge the economic cycle.

However, valuations for small caps remain inexpensive. In general, there is a correlation between buying small caps when they are cheap and subsequent returns.

These two elements are in conflict: the economic data suggests it is too early for small caps, while valuations suggest it may be a good moment to re-evaluate them. That said, market timing is difficult, and the economic cycle is almost certainly closer to the bottom than the top. This is particularly true in the UK, which only just missed entering a technical recession by the finest of margins. The time to revisit small caps is approaching and may be even closer for the UK than elsewhere. Our investment managers are watching the signals closely.

Sources:

¹ The MSCI World Small Cap Index, MSCI.com, [accessed 30 January 2023]

² Refinitiv/Evelyn Partners

³ Eun, Cheol S., et al. “International Diversification with Large- and Small-Cap Stocks.” The Journal of Financial and Quantitative Analysis, vol. 43, no. 2, 2008, pp. 489–523. JSTOR, [Accessed 30 January 2023]