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Are small cap companies still a bargain?

Are small cap companies still a bargain?

by | Aug 21, 2024 | Investments, Markets and Economy, Wealth Management

On 11 July, the US CPI data took the share market by storm. It was the fourth successive monthly decline, and at 3 per cent, it was the lowest annual inflation print in a year.

The fixed income markets had started 2024 expecting the US Federal Reserve would cut interest rates as many as four times over the year, but after some nasty surprises in March and April, there was even talk of another rate rise. The June print saw the odds of a September cut rocket and then the Federal Reserve Governor, Jerome Powell, all but confirmed it’s very much on the table.

So began what was being referred to as the Great Rotation as the market started to focus on those sectors and companies that would benefit the most from declining interest rates in an economy that was still expected to avoid falling into recession, and the hottest ticket in town was small cap companies.

The Russell 2000, one of two high profile US small cap indices, outperformed the NASDAQ and the S&P 500 by the most it ever has in a single day as well as over the following five days, rising by more than 10 per cent.

Then came the correction: higher than expected unemployment figures on 2 August saw perceptions about the risk of a US recession rise sharply, and the Russell 2000 gave back all those earlier gains.

In terms of their performance compared to their large cap peers, small caps have endured a rough past 10 years, with the Russell 2000 underperforming the S&P 500 by 32 per cent and the NASDAQ by more than 50 per cent – see chart 1.

Chart 2: the S&P 500’s PE ratio with and without the MegaCap 8

That outperformance by large caps has been underpinned by superior investment fundamentals, driven principally by the IT companies. Return on invested capital (ROIC) for large caps averaged about 10 per cent, double that of small caps, and free cash flow margins were 9 per cent compared to 2 per cent.

In other words, the large caps have been generating a higher return on every dollar they invest into their companies and ending up with more cash than their small cap peers.

On top of that, the small cap companies were, on average, carrying about four times the level of debt in proportion to their cash flow, so were more vulnerable to rising interest rates, especially given they averaged 40 per cent floating rate debt compared to the large caps at about 5 per cent.

But that was one of the reasons the Russell 2000 jumped so much when the market became convinced the next interest rate move is downwards, that leverage to interest rates becomes a good thing when they’re on the way down.

J.P. Morgan Asset Management recently wrote that a strong factor behind the small caps’ rally is that their valuations are as cheap as they’ve been this century, especially relative to large caps. The S&P 600, the other US small cap index, is on a forward PE ratio of 16x, versus a long-run average of 18x, whereas the S&P 500 is on 22x versus a long-run average of 17x.

The story for Australian small caps is slightly different. The Small Ordinaries index outperformed the ASX 200 quite handily right to the end of the post-COVID bull market in 2021 but has since given it all back during the period of rising interest rates. That underperformance over the last three years is despite the Australian large caps not having anything like the fundamentals or earnings growth of their US counterparts.

Chart 2: the S&P 500’s PE ratio with and without the MegaCap 8

The other consideration, of course, is that the Reserve Bank is not tipped to be cutting rates for a while yet, so more highly indebted companies are having to wait longer for relief.

So, are small caps still a bargain? The level of relative underperformance of Australian small caps versus large caps is almost as bad as it’s been in the past 30 years, and for the Russell 2000 versus the S&P 500, it’s about 20 years. If you’re a believer in mean reversion, you’d be looking for the catalyst and a reversal of the interest rate cycle might just be it.

On a straight PE ratio comparison, small caps again look cheap compared to large caps, but bear in mind the differences in fundamentals.

For smart investors who prefer a diversified portfolio, there’s always a solid argument for at least some weighting to small cap companies given that over the past 100 years they have, in total, handily outperformed their large cap peers. The phenomenal, albeit short, rally we saw in July is evidence that when small caps finally take off, they can move quickly.

Something to bear in mind about both US and Australian small caps is that one quarter of the companies in the Australian Small Ordinaries index, and about 45% of the Russell 2000, are loss making, so it’s one asset class where investing via an experienced fund manager with a strong track record can be beneficial.

A contrarian opportunity in small caps

A contrarian opportunity in small caps

by | Jun 7, 2023 | Investments, Markets and Economy, Small Caps

Contrarian investing is always difficult because, by definition, it requires swimming against the tide, which can be uncomfortable and tiring. While it’s certainly not for everyone, it is often where the best value and opportunity is to be found. Small cap companies in Australia and the United States may well be offering that opportunity right now.

Since the Australian share market peaked back in August 2021, the Small Ordinaries Index (XSO) has copped a way harder beating than its large cap peers falling by more than 20 per cent over the course of the market correction, while the ASX100, made up of the 100 largest companies on the Australian stock exchange, has dropped by only 5 per cent.

For a bit of longer-term perspective, the returns from XSO relative to the top 100 stocks is more than 20 per cent below its 20-year average, or more than 1.5 standard deviations. That is only 5 per cent away from its lowest level in at least the last 30 years – see chart 1.

 

The relative performance of the Small Ords<br /> vs the ASX100 is at a multi-year low

Similarly, the Russell 2000 (R2K) index of US small cap stocks has taken a similar beating during this market correction and is still down 22 per cent from the market’s high at the end of 2021. After tracking the large cap S&P500 for most of that time, over the past two months the performance gap is now the widest it’s been over that 17-month period.

Again, however, for some longer-term perspective, after the recent AI-driven rally in the mega cap tech stocks, the R2K’s returns relative to the S&P500 is about 27 per cent, or almost two standard deviations, below its 20-year average.

What is of far greater significance, though, is the valuation gap that’s opened up between US small cap companies and their large cap peers. When you compare their PE ratios, small caps are the cheapest they’ve been versus large cap stocks for well over 20 years and are now 2.5 standard deviations below the 20-year average – see chart 2, putting it in the 99th percentile.

US small caps are as cheap as they’ve<br /> been vs large caps for at least 20 years<br />

Luke McMillan, Head of Research for one of Australia’s best performing small cap fund managers, Ophir, points out that, unlike the GFC where markets fell because earnings collapsed, the current market correction is largely due to investor sentiment turning sharply negative, which gets reflected in a drop in the PE (price to earnings) ratio.

Not unusually, when the market experiences a sentiment driven correction, referred to as ‘PE compression’, small caps companies get hit harder than large caps as investors opt for the perceived safety of bigger companies.

And that can be the rub with investing in small cap companies. While it’s easy to get excited by the runaway small cap success stories that made early investors rich, like Afterpay or REA Group, there are far more stories of investors that have either lost everything or have watched their investments go nowhere year after year. The annualised volatility of the Small Ordinaries index is 25 per cent higher than the ASX100, in other words, investors need to be prepared to buckle up for a bumpy ride.

Many small cap companies have either no analysts covering them or very few, so getting your hands on reliable information can be difficult, especially if the company’s based overseas. That can make for great opportunities for those investors capable of picking apart a cash flow statement and balance sheet, and who are prepared to put in the time and effort to get to know a company in detail and spot the gems before the crowd. But, as McMillan says, a great small cap company needs a lot more than a good story; smart management and strong financials are critical.

While fund managers can find it a real challenge to beat large cap indices, making passive investing via an ETF an attractive option, because of the huge dispersion between profitable and loss-making small caps, it’s usually much easier for a good manager to beat the small cap index. The trick is finding those good managers.

The final thing any smart investor needs to remember when investing in a riskier asset like small caps, is to size the investment appropriately for both their portfolio and, importantly, their risk appetite.