“If it ain’t broke don’t fix it” seems to be the mantra that has rattled around markets in the past few years, with investors relying heavily on the performance of tech behemoths like the Magnificent Seven.
Take 2024 as an example. There has been plenty of uncertainty surrounding monetary policy and geopolitics, yet global equities are up more than 20% year-to-date. Markets have broadened out but tech has still delivered a huge chunk of that performance, with megatrends themes like artificial intelligence garnering significant attention.
There is no reason to suggest these large-caps cannot continue to grow, but the speed of growth has to be considered. Given how big they now are – several surpassed a market capitalisation of $1trn – history would suggest that it will be harder for them to sustain those levels of growth.
Then there is the unloved small-cap market (68% of all global companies) where times have been tough. The era of fast and forceful monetary policy tightening that began in 2022 was a headwind for interest-rate sensitive small-caps, which carry more floating-rate debt than their large-cap counterparts.
Global smaller companies normally account for 7-8% of the global stock market valuation, but by mid-2024 underperformance had seen this fall closer to 4%, a 50-year valuation low. Q3 2024 has been kinder as falling inflation, steady growth data and rate cuts took some of the pressure off, with the MSCI World Small Cap index returning 9.3% (vs. 6.1% for the MSCI World).
Regardless of this, the relative P/E ratio of the MSCI World Small Cap index to the MSCI World index currently trades at one of the largest discounts to its historical average, at -32%. We must remember, historically small-caps deliver stronger growth than large-caps. The MSCI World Small Cap index has delivered an average annual return since 2000 of 9.25%, compared with 7.43% for the MSCI All Companies World index.
Why now – can I wait a bit longer?
There are a host of reasons why now could be the ideal time for small-caps. Firstly, as mentioned, the strong growth at the top of the market has been exceptional, but can it last? Janus Henderson portfolio manager Nick Sheridan says the key to small-cap outperformance is the capacity they have to grow their earnings in a way that large-cap stocks will struggle to consistently match.
Global Smaller Companies Trust manager Nish Patel agrees exponential large-cap growth will be hard to maintain – he also cites the increased share buybacks (companies think their own shares are cheap) and M&A activity as a boon for small-caps.
Nish also points to rate cuts traditionally resulting in strong growth in this segment of the market. In previous rate cycles, the average small-cap has outperformed large-caps by over 10% in the following 12 months (26.6% vs.15.6%).
Europe and UK look particularly attractive
With forward P/E ratios in low double digits, both UK and European small-caps are trading very much at the bottom-end of their range since 2008. The challenges facing UK small-caps post-Brexit have been well-documented, but M&A and buyback have been on the up here. Balance sheets are also strong with almost half (45%) of UK small-caps in a net cash position. Political stability will help – but talk of government policy intervention focused on domestic equity allocation into UK equities could be a changer for the small-cap market.
Nick Sheridan believes Europe has arguably the most potential at a regional level, citing a number of fantastic companies exposed to “any structural growth theme you can name”. As a research note from BNP Paribas points out, the earnings per share growth expected by analysts for next year is stronger for European small-caps than for European large-caps – 15% EPS growth for the MSCI Europe Small Caps index versus 11% for the MSCI Europe index. Despite this, small-caps in the region trade at a 10% discount to large-caps.
Even the US has value to some degree
With forward P/E ratios around 22x, US small-caps do not appear particularly attractive from a valuation perspective, relative to their own history. But there are factors which indicate there could be further gains to be made here as well, not least that a second Trump presidency is expected to drive significant gains in small-cap stocks. The Russell 2000 index, which tracks US small-cap companies, has already seen substantial gains, indicating the optimism around his pro-business agenda.
Bob Kaynor, manager of the Schroder US Mid Cap fund, says the broadening out of markets beyond the Magnificent 7 has already started to benefit companies further down the market cap spectrum in the US, adding that there are a host of reasons to suggest US small-caps can deliver from here. For example, history shows US small-caps often perform well when inflation is in the 1-3% range; Wall Street forecasting a strong rebound in small-cap earnings; growth in the service sector bolstering returns; reshoring offering opportunities for US small-caps to step in as reliable suppliers; and that they are also the prime beneficiaries of the increased capital expenditures as companies look to lower costs.
History says now is a good time to look at this segment – it will need a brave step from investors but they are likely to be rewarded over the long term. Those who try to time this turn might end up missing the boat altogether. Those looking for a global smaller companies fund might consider the abrdn Global Smaller Companies fund, managed by Kirsty Desson; while those looking for regional exposure might consider the likes of the Unicorn UK Smaller Companies fund or the Janus Henderson European Smaller Companies fund.
Darius McDermott is managing director of FundCalibre. The views expressed above should not be taken as investment advice.