As put by Richard Weiss, senior vice president and chief investment officer of American Century Investments: “That’s the question of the day. Are small caps dead or just lying dormant?”
The “small-cap premium”, the historical trend where small-cap stocks have typically outperformed large-cap stocks over extended periods, has weakened significantly since the 1980s, and even more so over the past 10 years.
For more than a decade, US small-cap companies have consistently underperformed their large-cap counterparts.
During an American Century roundtable on 28 October, Weiss asserted that, at least according to conventional wisdom, the asset class is effectively “dead in terms of relative returns”.
“Private equity firms are keeping the better firms private longer and then launching them into either large caps directly after they’ve succeeded, or large tech companies are just coming in and buying these private companies right from them,” Weiss told the panel.
InvestorDaily previously covered how the number of initial public offerings (IPO) to the ASX is falling with companies opting to remain private rather than list on an exchange.
In turn, he explained that this theoretically leaves small cap indices with lower quality, less profitable small firms.
However, Weiss conceded that while strong evidence supports this theory, it only offers a partial explanation. Instead, he argued that several structural challenges are currently weighing on small-cap companies, which may not last forever.
First, he highlighted that small cap indices in the US have a greater concentration in financials, which have underperformed compared to the tech sector that largely dominates large cap indices.
Second, he noted that the interest rate environment of the last decade has been somewhat detrimental to smaller companies: “Because they’ve [interest rates] been rising, small cap companies are more leveraged, so it hurts them”.
He also pointed out that significant passive and exchange-traded fund flows are directed towards large-cap stocks rather than small ones.
“So you have all these other reasons why large caps may be outperforming and, importantly, indicating that it’s episodic, not a forever thing, and so small-cap companies will have their day in the sun again.
“Clearly, if you look back over history, you know, you get five or 10 years of one outperforming the other, and then it reverts,” he said.
For this reason, Weiss argued that keeping an allocation to small-cap stocks is “always a smart diversifier”, although he said he couldn’t predict when the asset class might see a turnaround.
Small-cap success
Closer to home, both Australian and global small caps have recently demonstrated strong performance, again indicating that a reversal of fortune remains a possibility.
Notably, this recent success has come despite Australia mirroring the US in its IPO challenges.
Richard Ivers and Mike Younger, portfolio managers for the boutique Prime Value Emerging Opportunities Fund, argued that Australia’s small-cap stock performance represents a “justified” turnaround – with more room to run.
“We see fundamental reasons why small cap outperformance could continue, driven by much stronger earnings growth and lower valuation multiples. We’re also seeing genuine bull market behaviour in certain sectors with some stocks running hot,” Ivers said.
Younger noted that, in retrospect, the small-cap industrials index hit its lowest point in October 2023, coinciding with the Reserve Bank of Australia’s final rate hike of the cycle.
“Since then, this index is +49.7 per cent versus the large cap index +38.6 per cent but has reversed only a small portion of the small cap relative underperformance over the last five years,” he said.
Adding to this, he said stronger earnings among smaller companies were an encouraging sign: “Share prices follow earnings, and there are many stocks where improved earnings are yet to show up fully in the share price, so there are currently some good buying opportunities.”
Younger also pointed to Macquarie Research, which estimates that small cap, ex-100 stocks will exhibit much stronger growth over the next few years to 2028. He added that these stocks are also currently trading at more attractive valuation multiples compared to large-cap stocks.
At the same time, Ivers and Younger cautioned that despite the apparent growth potential of small-cap stocks, investors must remain selective and prioritise downside protection.
“The last 10 years has shown us to ‘expect the unexpected’. It has also shown that market conditions can swing much faster than previous eras, and that brutal sell-downs can occur when momentum shifts,” Ivers added.
