Source: Bloomberg, Russell, S&P Global, J.P. Morgan Asset Management. Data as of 24 November 2023.
Structural challenges have also brought down the small cap premium. Today, large amounts of private equity and venture capital compete with public markets to provide equity financing for smaller companies. Increasing numbers of promising businesses are deciding to stay private or postpone public listings, deterred by increasing regulation in public markets. Smaller firms are also more frequently taken private today than in the past.
As a result, over the past decade small cap indices have measurably declined in quality. Before the financial crisis, unprofitable firms averaged a 27% share of the Russell 2000; today, that figure is 45%. Thus, investors are probably justified in demanding a higher risk premium for smaller cap stocks than in the past, which is reflected in their lower valuations.
As well as a decline in quality, the sector mix of small cap indices shows that many higher-growth industries are now underrepresented. In the MSCI World Small Cap Index, the technology and communications sectors are weighted 12 and four percentage points lower than in the MSCI World. By contrast, industrials (20%) and real estate (8%) feature heavily. 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.1
A more positive outlook for smaller companies
Given these structural challenges, we would not expect the small cap valuation premium to return to the circa 50% seen on average over the last 20 years.2 Nonetheless, as cyclical headwinds fade small cap stocks could rerate from currently depressed valuations.
Buying smaller companies during recessions has historically been a winning strategy, as the likelihood of central bank interest rate cuts and prospects of 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.3 Past performance is not a reliable indicator of current and future results.
Thus, while it may be too early to take advantage of historically attractive small cap valuations, at some point we expect a modest small cap premium to return. Our base case for 2024 expects mild recessions across developed markets. This scenario could present an opportunity for longer-term investors in the smaller company segments of equity markets – although given the larger quality dispersion of small cap indices, an active approach is likely prudent.