Declaring the demise of an asset class is a mistake people have made since the dawn of markets. It’s a temptation many on Wall Street succumbed to recently when small-cap stocks notched two-decade lows versus the S&P 500—only to rally sharply after the Federal Reserve’s dovish policy surprise last week.
Yet for all the short-term market noise, existential fears surrounding the investing style are longstanding and profound. Since markets soured at the start of 2022, the Russell 2000 is still down roughly 12%, while the S&P 500 and Nasdaq 100 have more or less recouped their losses.
Thanks to deep economic changes, smaller firms overall are less profitable, less exciting and more indebted—disadvantages they will struggle to overcome over the long run, skeptics warn. As private markets boom, the likes of Verdad Advisors see an industry increasingly starved of high-quality younger companies, while loss makers get listed and profitable darlings exit.
All that emboldened a Furey Research Partners strategist to sum up the threat to the asset class in blunt terms in a recent note: “It is time to face the facts—the “Death of Small Cap Equities” is upon us.”
“All of us here are tired of writing the essay that says ‘here’s why small-cap is going to work,’” said Jeff Burton, co-founder of small-caps specialist Furey, who says he penned the note with a whiff of melodrama in mind. “Our clients are well aware of some of the problems. They hear it from investors all the time.”
He still sees a resurgence for the cohort fueled by wide valuation discounts. Yet Burton understands the challenges that have spurred investor apathy. At the center of the concern is evidence of impaired profitability that some worry has become a permanent feature of the market landscape. According to Verdad, the median American small cap in 1995 posted gross profits of about 29% over assets. Now it’s just 14%—even excluding health care, with its share of profitless biotech and pharma stocks.
The contrast in balance sheets among big and small businesses has also become stark. Over the past two decades, the largest U.S. companies doubled their earnings relative to interest payments, Societe Generale SA data show. That fortified them against the impact of rising interest rates. Small caps are nowhere near matching the feat.
Stranger still, this deterioration has been mostly an American phenomenon; in Japan and Europe, little has changed, according to Verdad.
“We see secular reasons why it won’t re-rate back to those high levels,” said Thushka Maharaj, a multi-asset strategist at JPMorgan Asset Management, referring to the long-term outlook for U.S. small-caps. “It’s more profitable companies staying private because they have financing privately, but also large established companies growing their revenue because of this concentration in new innovative technology.”
Views like these are a warning to value hunters heartened by the recent green shoots in the Russell 2000 on signs the Fed is closer to easing monetary policy.
Problems for the investing style run beyond the near-term monetary outlook. And the theme of big-beating-little runs deep. Even among large caps, the concentration of gains in artificial-intelligence champions has meant that only about a quarter of S&P 500 members matched or exceeded the index’s 23% gain this year.
In a sign of mega-cap dominance, an equal-weighted version of the benchmark is set for its worst year versus the regular value-weighted one since 1998.
That’s giving succor to theories that American markets have been fundamentally transformed in the new age of tech and more than a decade of cheap money. Scalable software and networks are so winner-take-all that they favor the incumbent. And when that’s not the case, the new innovators are now remaining private for much longer thanks to the boom in private equity, the thinking goes.
“We’re seeing a greater increase in the number of just unprofitable companies that enter the universe” of listed small-caps, said Chris Satterthwaite, an analyst at Verdad. “There’s definitely some truth to the fact that the most interesting and exciting and perhaps coveted private companies are staying private longer.”