Importantly, however, significant valuation dispersion suggests that as investors gain more clarity about the health of the U.S. economy and trajectory of inflation and rates, small caps could lead the charge as we embark on the next bull run.
2022 was a year characterized by significant market volatility and an exodus from risk assets, but the pain was particularly acute for small cap stocks, which shed a fifth of their market value. Taking a step back, small caps have lagged large caps as measured by the S&P 500 Index by 227 basis points (bps) per year, on average during the past decade. As a result, clients have been increasingly asking about an emerging opportunity in small caps, particularly given this underperformance and how compelling smaller companies look from a valuation perspective. In fact, based on our own internal research, small caps have only been cheaper compared to large caps 27% of the time, with today’s valuation advantage akin to prior outlier episodes like the tech bubble and the financial crisis. More importantly, forward looking performance coming out of these periods is quite compelling; in the 10 years following the tech bubble, small outperformed large 8 out of 10 times and by over 400 bps per year on average.
In addition to these attractive valuations, small caps have done well in periods of rising rates and high, but declining, inflation. However, as monetary conditions remain tight and the Federal Reserve attempts to glide the U.S. economy to a soft landing in 2023, active management will be paramount. The small cap market is fraught with landmines – weak companies that have been able to survive in this era of easy money; at the end of 2022 approximately 40% of companies in the Russell 2000 Index were unprofitable. As rates continue to move higher and the U.S. economy weakens, these unprofitable companies will face mounting pressure. Furthermore, small caps tend to be more cyclical, and have greater exposure to health care, financials and industrials.
Equity markets will face a unique set of challenges in 2023, and small caps will not be immune. Heightened volatility looks set to persist in the face of uncertainty around monetary policy and the elevated potential for a recession. Importantly, however, significant valuation dispersion suggests that as investors gain more clarity about the health of the U.S. economy and trajectory of inflation and rates, small caps could lead the charge as we embark on the next bull run.