SMALL CAPS: IT'S TEMPTING BUT STILL A BIT EARLY

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Weekly

February 12, 2024

Small companies clearly underperform the main stock market indices

They have been more affected by the economic slowdown

To become interested, investors need to be considering a recession-free scenario

They must also expect the Mag 7 and Granolas craze to come to an end

CHART OF THE WEEK: "The underperformance of small caps widens"

STOCK MARKET ANALYSIS

For the past three years, companies with a capitalisation of less than USD 2 billion have underperformed those with large capitalisations, both in Europe and the United States (see Fig. 2). In the US, the cyclical slowdown has exacerbated an existing trend, with the Russell 2000 underperforming the S&P 500 since 2014. After posting an advance of +28%, the index of small listed companies is now lagging behind by -22% (see Chart of the Week). Against this backdrop, investors are wondering whether the time has come to allocate a larger proportion of their assets to this market.

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Small-cap companies are usually more sensitive to the economic cycle than large ones. More flexible and able to react quickly to market opportunities, they are sought after by investors when growth is strong and risk aversion is low. Conversely, in times of economic slowdown and uncertainty, small caps are more at risk. Their lower capacity to absorb shocks, limited exposure to international trade, sensitivity to domestic economic activity and high financing costs deter investors. For all these reasons, it is when the economy goes into recession that small caps suffer the greatest relative underperformance (see Chart of the Week & Fig. 3).

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With this in mind, everyone is trying to determine whether the economic cycle is in a phase of growth (no landing), slowdown (soft landing) or recession (hard landing). This may seem an ordinary question, but it is one that is currently provoking lively debate within the community of economists. Those who focus on the ratio of new orders to inventories (see Fig. 4) are very confident about the US economy's ability to generate growth. Those who concentrate on purchasing managers' confidence (see Fig. 5) expect a moderate slowdown. As for those who look at regional surveys to extrapolate the national trend (see Fig. 6), they have every reason to expect a recession. The econometric models on which our forecasts are based also lead to this last conclusion.

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For their part, equity investors, optimists by nature, are clearly part of the first group. The current level of the S&P 500 has already priced in an acceleration in US economic growth over the next few quarters (see Fig. 7). From this point of view, it is surprising that the small caps have not yet started to catch up with the large caps.

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In the past, the only time that large caps continued to be favoured by investors after such outperformance was during the internet bubble. In 1998-99, the 'TnT' craze allowed large caps to appreciate beyond all reason... before suffering a sharp correction. At a time when the 'Magnificent Seven' (Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, Tesla) and the 'Granolas' (GlaxoSmithKline, Roche, ASML, Nestlé, Novartis, Novo Nordisk, L'Oréal, LVMH, AstraZeneca, SAP, Sanofi) are generating much of the performance of the US and European indices, history looks set to repeat itself.

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In both the United States and the Eurozone, the earnings season for the fourth quarter of 2023 reveals a striking dichotomy: annual earnings growth is positive for large companies, but negative for small ones. This gap justifies the difference in performance between the EuroStoxx (+6.5%) and the EuroStoxx Small Cap (-3.2%) over the last twelve months. Valuation levels have moved in tandem, and now stand at 13x earnings (see Fig. 8). In the United States, by contrast, the performance of the S&P 500 is far too strong (+20.2%) compared with that of the Russell 2000 (-1.1%). As a result, the valuation of the former index is now 24.3x earnings, compared with 15.3x for the latter (see Fig. 9). The gap is becoming very favourable for US small caps.

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Conclusion:

Investors who rely on company fundamentals to increase their exposure to small caps must accept two risks: a recession and a repeat of the internet bubble. They should also bear in mind that it is mainly in the United States that small caps offer a discount to large caps.

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