The curious case of US small-cap stocks

Company News

by Peter Milios

A fundamental principle in finance is the correlation between risk and returns. It's widely acknowledged that smaller company stocks tend to outperform larger ones in the long term. This principle is deeply ingrained in both investment theory and practice.

Admittedly, smaller company stocks can be more volatile and may endure prolonged periods of poor performance, as evidenced in the 1960s and late 1990s. However, empirical studies conducted by academics over the decades consistently demonstrate that "small-capitalization" stocks outshine larger stocks over time. This trend holds true across all major markets worldwide. Consequently, there are hundreds of billions of dollars invested globally based solely on this principle.

Since its inception at the end of 1978, the Russell 2000 small-caps index has consistently trailed behind the S&P 500 large-capitalization index, marking a departure from a century of return data observed across various countries.

These returns primarily reflect price changes, as total return indices do not extend back this far. However, factoring in dividends would likely reinforce the trend. Larger companies typically offer more substantial dividends, potentially exacerbating the underperformance of small-cap stocks. This trend becomes even more pronounced when considering data from 1984, when the Russell 2000 index was established (with historical data available from the late 1970s).

One might be tempted to attribute this phenomenon to the current dominance of the top 10 largest US stocks, which are outperforming even the broader S&P 490 index. Importantly, however, this trend is not mirrored internationally, where the principle of small being greater than big remains largely intact.

However, in the US, it appears that the small-caps effect is... disrupted?

This holds significant importance, given the US's status as the largest and most influential capital market, commanding a significant portion of the small-caps industry. According to Morningstar, of the nearly $1.7 trillion invested in dedicated small and mid-cap funds globally, nearly $1.3 trillion is allocated solely in the US.

Moreover, the US possesses the most extensive and comprehensive dataset supporting the small-caps effect. If this trend is faltering there, it raises questions about its validity elsewhere.

The recent ascendancy of the Magnificent Seven and other major stocks goes a long way in elucidating the recent lag in performance observed in US small caps.

Even within the S&P 500, a noticeable performance gap exists between the largest stocks and the rest. Currently, the top 10 companies comprise a third of the total market capitalization of the index and contribute one-fourth of the earnings generated by America's 500 largest companies, as per Goldman Sachs.

Smaller companies are disproportionately impacted by rising interest rates due to several factors. Firstly, their higher relative debt burden exacerbates the situation. According to Furey Research Partners, their aggregate net debt currently exceeds three times earnings, compared to under two times for large companies.

Additionally, the composition of their indebtedness contributes to their vulnerability. Unlike larger US companies, which predominantly borrow long-term at fixed rates through the bond market, smaller companies rely more on floating-rate debt. This type of debt has become significantly more expensive over the past two years.

Moreover, smaller companies face the challenge of debt maturing within the next year, making refinancing a more costly endeavor.

According to Bank of America, maintaining current interest rates would result in a significant 32 percent decline in earnings over the next five years. Even if the Federal Reserve begins to lower rates as anticipated, small-cap earnings are still projected to decrease by 24 percent, as indicated by BofA's Jill Carey Hall.

Nevertheless, the recent underperformance of US small caps compared to the broader stock market since the 1980s, when research initially demonstrated their long-term outperformance, cannot solely be attributed to companies like Nvidia and Microsoft or a single cycle of interest rate hikes.

While smaller companies have historically been perceived as somewhat opaque, with less liquidity in their securities and fewer analysts covering them, the landscape has evolved significantly. According to Goldman Sachs, the median stock in the Russell 2000 index is only analyzed by five analysts, and one in seven stocks have minimal or no coverage at all, compared to the median S&P 500 stock, which is tracked by 18 analysts. In contrast, Microsoft alone has 66 analysts covering it, based on Bloomberg data.

However, the reality today is that there is more research and information available on smaller US companies than ever before. This increased transparency means that these companies are not consistently undervalued, which could diminish any historical size premium they may have enjoyed.

In the past, accessing quarterly earnings and annual reports often required physical requests and mail delivery. Today, the situation is vastly different, with instant access to detailed financial statements online. The quality of financial reporting has also significantly improved over time. The best financial statements available in the 1980s would likely pale in comparison to the lowest-quality reports filed today, and they are readily accessible to anyone with an internet connection.

Peter Milios

Peter Milios is a recent graduate from the University of Technology - majoring in Finance and Accounting. Peter is currently working under equity research analyst Di Brookman for Corporate Connect Research.

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