When JPMorgan Asset Management’s multi-asset team recently examined the small-cap premium—the higher returns these stocks are meant to reap commensurate with their riskier nature—they cut their forecasts to the lowest in years, citing the change in sector mix and growth in private capital. These small companies were actually beating the large in terms of sales growth during the 2000s—a reflection of their youthful potential. Yet by the past decade these levels had converged, data compiled by JPMorgan Asset Management show.
In Verdad’s analysis too, listed companies both big and small have become less profitable over the past two decades, but the drop has been far steeper for the latter, driven by the worsening quality of new market debuts.
Among smaller American stocks, a growing percentage has been financial or biotech stocks, neither known for their stellar profits. Meanwhile, tech—the S&P 500’s superstar sector—has been contributing a falling portion to the profits of small caps overall.
All that has, in turn, widened the difference in leverage between the big and small. While U.S. large-caps have mostly financed themselves with bonds with long duration and fixed interest rates, smaller firms are now facing more pressure from debt coming due and rates surging, according to SocGen.
“We’ve seen the largest technology companies particularly in the United States but globally become even larger, and part of that has to do with the abundance of capital that these companies could expand,” said Kent Chan, equity investment director at Capital Group, which runs a $71 billion global small-cap fund. “If you go back to 1999 to 2000, the exact same thing happened and then the cost of capital increased and you started to see smaller companies innovate outside large companies.”
Chan, Verdad’s Satterthwaite and Furey’s Burton are all quick to note these top-down observations belie a treasure trove of profitable gems at potentially dirt-cheap prices. That’s a silver lining to money managers: Worsening trends mean there’s a greater case for stock picking, at a time when the S&P 500 is looking exceedingly hard to beat.
The S&P SmallCap 600 Index, which already strips out profitless stocks, is trading near the lowest valuations ever versus the large-cap benchmark in data going back to 2005. In that lens, morbid references are only a sign that small caps have been unfairly maligned.
“When you get nominal growth decelerating you get interest rates coming down—that should be good for small-caps,” said Brad Neuman, director of market strategy at Alger. “It kinds of depends on whether it’s a soft or hard landing and how far nominal growth decelerates, but I think the valuation discounts are unsustainable.”
Capital Group’s Chan agrees the market looks oversold, though he also adds he’s finding better bargains among small firms outside the U.S.
Yet the concern now: As the best startups choose to stay private for longer, small-cap investors simply have a worse slate to choose from. That reflects a long-term trend. Except for a surge in 2021, the number of public debuts has dropped since the 1990s, and companies coming to stock exchanges are now typically more mature, data compiled by University of Florida economist Jay Ritter show.
The number of stocks in the U.S. has fallen 45% since their 1997 peak, with the small-cap count down by 60%, according to the Center for Research in Security Prices.
So, is the asset class lifeless? Not exactly, according to Burton, who says he titled his note partly on the hope of marking a bottom.
“Some of these issues that are plaguing small cap are real, but our view is they’re largely discounted now,” he said. “If we got close to taking the curse off small-caps by writing the death of small-cap equities, so much the better.”
This article was provided by Bloomberg News.