With large cap equities across the world sitting on elevated valuations, optically cheap small caps might seem enticing. Historically, small cap stocks have traded at a premium to their large cap counterparts – but recently, this premium has disappeared.

Current cheapness reflects both cyclical and structural factors. Structurally, the growth of private markets and the rising regulatory burden of listing publicly have weighed on both the quality and quantity of smaller firms listing, and therefore on small cap indices. These fundamental shifts may prevent the small cap premium returning to its historical highs.

Nonetheless, as cyclical challenges fade, smaller firms retain the potential to outperform large caps. An active approach to investing in small cap stocks can lean against the structural shifts that have weighed on the small cap premium in recent years.

Cyclical headwinds for small cap stocks

Before the Covid pandemic, small cap stocks often proved a good choice for investors able to take on more risk to potentially enhance their portfolio returns. Small caps had provided long-run excess returns over large caps for several decades, which left them trading at higher valuations than their corresponding large cap indices. Commonly cited reasons for the small cap valuation premium included these firms’ inherently greater growth potential, and their stronger mergers and acquisitions prospects.

However, after an extended period of underperformance, the global small cap premium has now disappeared. The MSCI World Small Cap Index currently trades on a forward price-to-earnings (P/E) ratio of 17x, well below the MSCI World’s 20x valuation.

Cyclical factors have contributed to the disappearance of the small cap premium. On average, small cap stocks have more debt relative to their earnings than larger firms. Smaller firms also tend to have more floating rate debt – around 40% of Russell 2000 debt (excluding financial firms) is floating rate, compared to less than 10% for the S&P 500 – and small caps’ fixed rate debt has a shorter average maturity. Thus, when policy rates are elevated, as they are now across most Western economies, small cap earnings tend to suffer more than large caps, given smaller firms typically have relatively larger and more rate-sensitive debt burdens.

Alongside this, the sector composition of small cap indices tends to be more sensitive to the economic cycle than that of large cap indices. For example, the MSCI World Small Cap Index features more industrial and consumer discretionary firms (sectors more exposed to economic fluctuations) than the large cap MSCI World.

In today’s environment of heightened uncertainty, smaller firms’ relatively larger debt burdens and greater economic sensitivity has weighed on their performance, as investors retreat into higher-quality large cap names. Since the start of 2024, the MSCI World Small Cap Index has underperformed its large cap counterpart by 13 percentage points on a US dollar, total return basis.

Structural challenges for small cap stocks

More fundamentally, small cap indices also face structural challenges such as the growth of venture capital and private equity firms, and the growing regulatory burden on listed firms. These structural shifts have contributed to a longer-term decline in the small cap premium.

The growth in private markets over recent decades has been enormous. In 2000, private equity and venture capital firms managed a combined $600 billion in assets. Today, that number exceeds $10 trillion. This massive expansion in private capital means promising smaller firms can fund their growth in private markets without ever needing to go public. Thus, many of the star startups that previously would have propelled the returns of small cap indices now contribute to private market returns instead.

The rising regulatory burden involved with listing publicly further disincentivises firms from entering small cap indices. This burden includes upfront listing costs, but also the cost of ongoing disclosure requirements and regulatory compliance. Smaller firms with access to private capital are able to avoid these regulatory costs – and increasingly choose to do so by remaining private for longer. The median time to initial public offering (IPO) in the US has risen from five years in 2000 to 14 years in 2024. Many firms now list straight into large cap indices.

At the same time as fewer private companies are choosing to list on small cap indices, promising smaller firms are also leaving those indices. Smaller listed companies that might have posted strong public market returns for years are now being taken private by private equity firms before they ever reach scale. This cuts short the contribution of potential outperformers to small cap indices, removing some of the potential upside available in the asset class.

Small cap stock indices have declined in quality

More recently, a flow of lower-quality companies into small cap indices has presented challenges for the asset class’s returns. This influx reflects a rising number of venture capital-backed IPOs where listing companies have prioritised growth over sustainable profitability. As a result, the share of IPOs with an unprofitable listing company has risen from less than 50% in 2010 to over 75% in 2022. These unprofitable businesses have generally underperformed post-IPO, weighing on the headline performance of small cap indices. The IPO boom of 2020 and 2021 exemplifies this trend: over 70% of the IPOs in this period have posted negative returns over the following two years.

This influx of unprofitable companies has contributed to a decline in the quality of small cap indices. Before the global financial crisis, unprofitable firms averaged a 27% share of the Russell 2000 by market cap; today, that figure is 46%. As a result, revenue growth across large and small cap indices has converged. Average US small cap revenue growth has not exceeded large cap revenue growth from 2010 to date.

The sector composition of small cap indices has also been affected: they now tend to feature fewer growth stocks. In the MSCI World Small Cap Index, the technology and communications sectors are weighted 15 and 5 percentage points lower than in the large-cap MSCI World Index. In contrast, industrials (over 20%) and real estate (8%) feature heavily.

Enhance portfolio returns with a selective approach to small caps

Given the decline in quality of small cap indices and their shifting sector composition, investors are probably justified in demanding a higher risk premium than in the past, which is reflected in small caps’ lower valuations. Thus, we would not expect the small cap valuation premium to return to the c.50% average seen over the last 20 years.

Nonetheless, as cyclical headwinds fade, smaller stocks could re-rate from their currently depressed valuations. With a lot of bad news already in small cap prices, a turn in newsflow could prompt a positive shift. Indeed, buying small caps in the middle of downturns has historically been a winning strategy, as the likelihood of central bank rate cuts and prospects for an economic recovery boost smaller firms over their larger counterparts. Over the three years following the start of a recession, the Russell 2000 has outperformed the S&P 500 by an average of 22 percentage points.

More structurally, for investors able to take on more risk, an active small cap strategy can still enhance the returns available in equity portfolios. Private markets are not a perfect substitute for small caps, given their lower transparency and liquidity, and small cap indices retain an inherently larger growth potential than their large cap counterparts. A selective approach can help investors in small cap stocks avoid their structural headwinds, as well as take advantage of the higher dispersion in small cap indices.

Small cap stock valuations can offer long-term opportunity

Structural shifts are a major driver behind the recent disappearance of the small cap premium: promising smaller firms with access to a large pool of private capital often now choose to avoid the regulatory burden of the public markets. This, paired with private equity firms taking private the most innovative smaller listed firms, has measurably lowered the quality of small cap indices over recent years.

However, cyclical headwinds – such as elevated interest rates and ongoing economic uncertainty – have also contributed to today’s depressed small cap valuations. These valuations offer an opportunity for longer-term active investors. As cyclical challenges fade, smaller firms have the potential to outperform, reinstating a modest small cap premium. An active approach to investing in smaller stocks can help investors take advantage of this, while avoiding many of the structural headwinds that have dampened small cap performance over recent years.