Profits from US small-cap companies have stabilised recently after falling for most of 2023. We believe slippage by the segment’s Russell 2000 index after last summer has added to the case for a prolonged bounce by small caps, much like similar recoveries seen in the past.
In the last 35 years, three similar-sized falls were followed by three to five years of robust performance. Scope for a similar bounce, coupled with rising investment intentions and favourable valuations relative to those of large-cap stocks, should make 2024 an attractive entry point for investors looking for outsized returns from small, innovative companies early in their lifecycle.
Macroeconomic environment: No immediate risk
Recession in the US – much vaunted a year ago – has not happened: the economy has continued to show surprising resilience. The preliminary estimate of fourth-quarter growth was 3.3%.
One key factor for the continued economic expansion is domestic consumption, driven by a robust labour market and sustained wage growth. In addition, the prospect of interest rates falling in 2024 is likely to reassure many businesses and households.
Meanwhile, a rebalancing of the labour market is underway, although more slowly than expected. As the US Federal Reserve (Fed) battles to bring inflation down to its 2% target, the ‘economic sacrifice’ (often in terms of rising unemployment) that is often the price paid to stamp on the inflation brakes appears to have been avoided so far.
Gauging company intentions
Business conduct surveys can help gain a better understanding of companies’ investment intentions. In manufacturing, after 10 to 15 years of under-investment due to off-shoring, one survey has highlighted a growing willingness since Covid to re-onshore manufacturing. This should be a long-term trend that government aid could fuel.
In the shorter term, according to the Institute of Supply Management (ISM) Purchasing Managers’ Survey, tech companies believe ‘expectations of Fed rate cuts should support investment.’ Another business survey recently found that a large majority expects sentiment to improve in 2024 as interest rates fall. Rising investment intentions should favour small businesses.
As CEOs of large companies regain confidence, large-scale mergers and acquisitions could pick up, with the quality of their economic and financial fundamentals making small caps possible targets.
A history of bouncing back
There is one particularity of the Russell 2000 index that we believe justifies the interest that US small caps are currently attracting.
As can be seen below, large annual declines by the index (by 20% or more) have been relatively rare and have generally been followed by three to five years of strong performance. The relative opportunity for small caps is typically enhanced by a multi-year period of underperformance and extreme levels of relative cheapness compared to large caps.
Profits of small-cap companies in the Russell 2000 fell by more than 15% through early 2023 before stabilising in the second half of the year. A double-dip earnings recession has been extremely rare, so a further deterioration in 2024 would be very much anomalous.
The current level of the forward 12-month price/earnings ratio is low compared to its long-term history. Valuations of small caps now appear to be inflecting as a less restrictive monetary policy is becoming a near certainty with most of the debate centred on the pace and degree of softening rather than the direction of policy rates.
Our approach
Our selection of stocks from the Russell 2000 has consistently been based on detecting companies likely to see steady earnings growth – companies whose business has been delivering over the long term and whose innovative business model offers them clear competitive advantages.
Finding business models that meet these criteria at the time they are set up requires understanding sector-specific characteristics and industry-specific processes – capabilities that we can bring to bear, either through our analysis of the sectors involved or direct professional experience.
In-depth knowledge of the sector makes it possible to evaluate financial criteria more precisely. In the small-cap universe, the relevance of a given valuation multiple varies greatly depending on the company’s sector or activity.
In-depth industry and company knowledge is also an asset in establishing and monitoring environmental, social and governance (ESG) criteria when selecting small caps. Our Sustainability Centre provides the data for the ESG scores and carbon footprints.
We believe the current macro and microeconomic fundamentals for small-cap stocks are buoyant enough to merit investor attention. Far fewer financial analysts cover this universe, creating ‘inefficiencies’ which, in our view, result in opportunities to generate alpha.
Successfully identifying mispricing at the stock level while mitigating other risks, in our view, provides a backdrop for exceptional risk-adjusted returns with remarkable consistency.
Disclaimer
