DEEP - Historical Moment For Small Caps
Summary
- Small caps have trailed the broader index in eight of the past ten calendar years.
- While a small reversion to the mean could represent a meaningful buying opportunity in small caps, we believe simple indexation is a risky way to invest in small caps.
- High-quality active managers with a disciplined focus on firms with above-average profitability, strong free cash flow, and sustainable earnings could prove to be an attractive addition to your small-cap allocation.
By Lee Arden Arcamone
For skilled active managers, a multi-generational opportunity may be brewing in small-cap stocks.
The last decade has been relatively rough for small-cap investors as globalization, tame inflation and low-interest rates pushed the valuations of large companies to new heights. Now those economic winds appear to have shifted, and as more companies re-shore their operations and increase capital spending, we believe active managers with a keen eye for U.S.-centric small caps may have a once-in-a-generation opportunity to deliver compelling results.
The Russell 2000 Index has significantly lagged the S&P 500 Index over the past ten years, delivering annual returns of 10.13% vs. 13.34%, respectively, as of November 30, 2022. Small caps have also trailed the broader index in eight of the past ten calendar years. Today, small caps represent just 1.3% of total U.S. equity market capitalization - near a 100-year low and well shy of the long-term average. Relative small-cap valuation - on a median trailing-12-month-P/E basis, excluding non-earners - is also at a record low. The last time relative valuation was near the current level was January 2000. In the ten years that followed, the Russell 2000 appreciated 5.44% annually; the S&P 500, a mere 0.41%.
While a small reversion to the mean could represent a meaningful buying opportunity in small caps, we believe simple indexation is a risky way to invest in small caps. A big reason: The quality of the Russell 2000 Index, in our view, has deteriorated in recent years. Today over 40% of the companies in the Index are non-earners; financial leverage is high, too, with net debt (much it floating) equal to 3.3 times EBITDA. That fragility could make many small caps more vulnerable in a slowing economic environment with rising interest rates.
In our view, high-quality active managers with a disciplined focus on firms with above-average profitability, strong free cash flow, and sustainable earnings could prove to be an attractive addition to your small-cap allocation.
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Historical Moment For Small Caps