The Bull Case For Small Cap Stocks Keeps Getting Better

By Andrew Prochnow

Large market capitalization companies, particularly those tied to the technology sector, have demonstrated significant success in 2023. The S&P 500 index, representing a majority of the nation’s prominent large-cap firms, has experienced a 21% enhance this year. Additionally, the Nasdaq 100, comprising an exclusive selection of large-cap tech enterprises, has surged by around 50% in 2023.

In contrast, the Russell 2000, which concentrates on small-cap stocks, has only advanced by 8% year-to-date. Given this substantial difference in performance, it is not surprising that small-cap stocks currently exhibit an extreme valuation gap relative to their large-cap counterparts.

For clarification, small-cap stocks are typically identified as those with market capitalizations ranging from $250 million to $2 billion. Alternatively, some define the small-cap category as encompassing the bottom 10% of all publicly traded stocks based on market capitalization.

Remarkably, in 2023, not only are small caps trading at a significant discount compared to large-cap stocks, but they are also trading below their historical valuations.

For example, the “average price/fair value” ratio for small cap stocks is roughly 0.78 at this time, while the ratio for large cap stocks is closer to 0.95, according to data compiled by Morningstar.

For this metric, a ratio over 1.00 generally indicates that an underlying is overvalued, while a ratio under 1.00 generally indicates its undervalued. Extremes in this ratio are generally viewed as “deep discounts” to fair value, or “exorbitantly overpriced.” That indicates that large cap stocks are trading closer to fair value, whereas small cap stocks are trading at a deep discount to fair.

On top of that, a quick review of the price/earnings ratio for both small cap and large cap stocks appears to corroborate those findings. At present the price/earnings ratio for small cap stocks is about 14, while the price/earnings for large cap stocks stand is closer to 20.

The price/earnings metric is commonly used to evaluate relative valuations, and is computed by simply dividing a company’s share price by its earnings per share. Generally speaking, the higher the ratio, the more investors are paying for a smaller chunk of a company’s earnings.

At present that means investors and traders are willing to pay a significant premium for large cap stocks.

Moreover, the 10-year average in the small cap P/E is about 18 (as compared to the current level of 14), indicating that prices in the small cap universe are depressed relative to their own historical valuations as well.

Additional Risk-Reward Considerations in the Small Cap Universe

As many investors and traders are well aware, a low valuation doesn’t always liken to being “cheap” or “inexpensive.” The fact that small-cap stocks are trading at reduced valuations doesn’t necessarily imply an imminent rebound.

However, when considering the broader “macro” perspective, there are reasons to be optimistic about the future of small-cap stocks. Here, “macro” pertains to macroeconomics, encompassing the broader economic conditions, trends, and policies influencing financial markets.

From a macro standpoint, small-cap stocks have encountered more significant challenges than their large-cap counterparts throughout much of 2023. Two primary obstacles include higher interest rates and the looming threat of a recession.

Elevated interest rates are a general drawback for the entire corporate sector, but the impact of higher rates can be particularly challenging for small caps. Smaller companies often rely more on credit to fuel their revenue and earnings growth. Consequently, when interest rates rise, small-cap stocks have less capital available for expansion.

This situation becomes even more difficult in deteriorating economic conditions, as the financial sector becomes less inclined to lend to smaller companies. Smaller enterprises inherently pose a higher credit risk than their larger counterparts, all else being equal.

As most are well aware, the U.S. economy has been threatening to tip into recession for many months. On top of that, the U.S. financial sector experienced a mini crisis earlier in 2023 when some of the country’s regional banks started imploding.

Unfortunately, in response to that crisis, the banking sector has been largely forced to tighten its lending standards. Along those lines, survey data from the banking sector indicated that 50% of respondent firms tightened their lending standards in Q2 of 2023.

All told, that means small cap companies have been facing a double whammy when it comes to securing much-needed credit in 2023-higher rates and tougher lending standards. And not surprisingly, this has resulted in an overall contraction in total lending, as illustrated below.

Considering all of the above information, one can see how smaller companies might have struggled in 2023, and why small cap stocks have consequently lagged behind large cap stocks in terms of returns.

However, there’s reason to believe that the worst might be over, and that could be a great thing for the small cap universe.

First, it appears that the Federal Reserve is done raising interest rates. On top of that, it also looks appreciate the risks of a 2024 recession are abating. Both of those are key developments, because they should ultimately contribute to an improved lending environment.

Historically, recessions have been appreciate kryptonite for small cap stocks because they don’t possess the financial resources to withstand periods of slowing (or negative) sales growth. Assuming that a severe recession is off the table, that means the potential upside for small cap stocks in 2024 has shifted dramatically.

Instead of being viewed as a potential problem area in the markets, small cap stocks might soon be viewed as fertile ground for better-than-expected performance.

Impact of the “Magnificent Seven” on Large Cap Stocks

One other factor that can’t be overlooked in 2023 is the impact of the so-called “Magnificent Seven” (aka “S&P 7”) on the large cap universe.

The Magnificent Seven is a nickname for seven of the best-known (and often top-performing) stocks from the S&P 500, including Alphabet Inc. (GOOGL) (GOOG), Amazon.com, Inc. (AMZN), Apple Inc. (AAPL), Meta Platforms, Inc. (META), Microsoft Corporation (MSFT), NVIDIA Corporation (NVDA) and Tesla, Inc. (TSLA).

This year, red-hot performance in the Magnificent Seven has dramatically impacted the complexion of the S&P 500-particularly at the top end of the food chain. Due to their surging valuations, the Magnificent Seven now constitute a whopping 29% of the S&P 500’s total market capitalization, which is the highest percentage on record for just seven stocks.

Moreover, the Magnificent Seven has returned 71% on average in 2023, while the balance of the S&P 500 (493 stocks) has returned just 6% on average. That means the Magnificent Seven is the primary reason that the S&P 500 is up nearly 20% year-to-date.

Interestingly, the fundamentals appear to uphold that degree of outperformance. According to Goldman Sachs, the Magnificent Seven is expected to grow sales at a rate of 11% (on average) through 2025, whereas the balance of the S&P 500 is only expected to grow sales at 3% (on average).

These seven companies also dominate to a greater degree when it comes to generating profits. The Magnificent Seven averages about 19% when it comes to net profit margins, whereas the remainder of the S&P 500 averages closer to 10%.

In 2023, the Magnificent Seven have undoubtedly benefited from the emerging potential associated with the commercialization of artificial intelligence (AI). And these stocks will likely ride that wave even higher in 2024. But better-than-expected economic growth should actually serve to boost the fortunes of the other 493 companies in the S&P 500, as well.

Taken all together, that means the prospects look bright for both small cap companies and large cap companies in 2024. However, with the small cap universe currently trading at depressed levels relative to large caps, investors and traders should arguably give this niche a closer look heading into the new trading year.

Along those lines, four key ETFs focusing on the small cap universe are highlighted below (sorted by year-to-date return).

• Vanguard Small-Cap Index Fund ETF Shares (VB), +11%.
• Vanguard Small-Cap Value Index Fund ETF Shares (VBR), +9%.
• iShares Russell 2000 ETF (IWM), +8%.
• iShares Core S&P Small-Cap ETF (IJR), +8%.

To review some top-performing small cap tech stocks from 2023-including those levered to the emerging AI sector-readers can check out this previous article.

Andrew Prochnow has more than 15 years of go through trading the global financial markets, including 10 years as a professional options trader. Andrew is a frequent contributor Luckbox Magazine.