Robert Starkey is a portfolio manager at Schroder Investment Solutions
Investing in smaller capitalisation (small cap) stocks when economic conditions are tough can feel uncomfortable.
Yet, history tells us that this can be a good time to start considering whether these companies deserve a place within a diversified portfolio.
We analysed data for the past five decades to get some insights from history to test this our thoughts.
The stock market gazes into the crystal ball
One of the best leading indicators is the stock market itself.
This is because investors are not only concerned with today’s headlines, but also how the future will unfold.
Investors anticipate how the future might unfold and then transact in company shares accordingly, driving the share price up or down in advance of actual news.
This means – for example – when a company announces how much it has grown its sales by, the share price might not change on the day if the company grew by the amount that investors expected.
What rather tends to send the share price moving on the day is when the announcement is above or below the expectations that were formed in advance.
Small cap stocks are no different in this way, and this can be a clue to guide us to what may be in store for their future.
One-year cumulative return for global large vs small companies (USD)
What the market expects
Over the past year, the fortunes of large and small companies worldwide have diverged.
This was primarily driven by the largest, so-called magnificent seven companies in the US, but also reflects the risks associated with owning smaller companies, which are more sensitive to the economic cycle.
There are a few reasons investors may favour larger companies in the late phase of an investment cycle.
Larger companies generally have multiple research analysts interpreting their performance which reduces uncertainty, they generally have easier access to finance in times of need, and they have multiple diversified products to sell which helps stabilise their cash flows.
This makes larger companies an attractive offering going into an economic slowdown. But as the above performance chart shows, this may have already been acknowledged by the market.
The key question is whether small cap stocks may have enough ‘bad expectations’ in their price; we could look to history to guide us.
We have crunched the data going back to 1980 to find out. We studied how large and small cap share prices behave during each phase of the investment cycle.
The table below shows that investing in small caps when the environment feels uncomfortable has generated good results, when investors take a long-term approach.
While the average returns from small cap and large cap stocks in the expansion and slowdown phases have been similar over this period, small cap stocks have – on average – delivered more than double the returns from large caps through both the recession and recovery phases.
However, no two cycles are exactly alike, and the current cycle may provide its own clues as to what may lie in store for investors.
Small caps have performed better in the recession and recovery stage of the market cycle since 1980
Positioning for the next phase in the economic cycle
While it’s always challenging to identify the exact turning points in any economic cycle, we are starting to see some evidence building that we are closer to a turning point than we have been in the past.
Our study provides evidence that you tend to get rewarded for looking ahead to when smaller companies will do well again.
We are starting to find some attractive opportunities among small caps, particularly in regions that have already experienced the pain of higher interest rates. When markets do recognise that a new phase in the investment cycle has begun, stock prices will often change sharply and suddenly.
While it’s important to be mindful that investment performance can be hit by increasing the allocation to smaller companies too early, it’s prudent to make sure you have a seat at the table to avoid missing out on small cap performance, which often arrives suddenly.
We have identified an opportunity in the USA, where the fortunes of all companies outside of the ‘Magnificent 7’ have all faced headwinds, and this has been more pronounced for smaller companies.
For example, Smaller companies – as measured by the S&P 600 – have seen their earnings decrease by 16.6 and 14.4 per cent in the second and third quarters of 2023, indicating that smaller companies may have already experienced their intra-cycle pain.
This pain is already being reflected in valuation levels approaching half of that of their larger counterparts.
To capture this view, we have implemented our view by allocating to a Fisher Investments Fund. We believe the fund offers a unique approach to small and medium sized companies with a focus on top-down macro, sentiment and political factors.
Their philosophy promotes a flexible approach, not tied to one style or biased to one fundamental process. We view this as a positive attribute while we navigate a potential transitioning phase of the global economy.
Outside of the USA we have been more selective. Within Emerging Markets we previously had a position in smaller companies, but we have closed this position at a profit.
Robert Starkey is a portfolio manager at Schroder Investment Solutions
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