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.

Part of the reason the small cap premium has disappeared is cyclical. On average, small cap stocks are more geared to the economic cycle and more financially levered than larger firms. In a late cycle environment with lingering recession risks and elevated interest rates, smaller firms thus look less attractive.

In particular, small caps are more vulnerable to recent interest rate rises – the largest increases in several decades. Smaller firms’ debt is more likely to be floating rate, and their fixed rate debt has a shorter average maturity, implying larger upcoming refinancing needs. For example, 38% of Russell 2000 debt (excluding financial firms) is floating rate, vs. an equivalent 7% for the S&P 500.

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. This introduces a negative selection bias into small cap indices.

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, more traditionally innovative industries are underrepresented. In the MSCI World Small Cap Index, the technology and communications sectors are weighted twelve 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

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 small caps during recessions has historically been a winning strategy, as the likelihood of central bank 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

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 (see our 2024 Investment Outlook). This scenario would present an opportunity for investors in the smaller cap segments of equity markets – although given the larger quality dispersion of small cap indices, an active approach is likely prudent.

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.