Like Taylor Swift’s career, small-cap stocks are set for a rebound

March 9, 2024
Written by David Barr
Like Taylor Swift’s career, small-cap stocks are set for a rebound

As published in the Financial Post on 9 March 2024.

Taylor Swift just won her 14th Grammy award and the Eras Tour surpassed the $1 billion mark with over 4 million tickets sold across 60 tour dates. Today, it’s hard to imagine that in 2016 Swift’s career was on the skids. Yet by 2017, with her “Reputation” album, Swift had become resilient, mature, and a formidable performer on her own terms. I hope Swifties will forgive me, but Taylor’s career reminds me of what has been happening with small-cap stocks: short-term troubles giving way to very positive outcomes. Because, contrary to popular opinion, I see green shoots in the small-cap space due to four catalysts having the potential to create a 3-to-5-year period of outperformance.

“Cruel Summer”

2023 was not a banner year for small cap stocks. The one-two-punch of higher interest rates and recession fears drove investors to the perceived safety of cash and the big names (e.g. ‘The Magnificent Seven’). Typically, smaller companies do not have the same access to capital raising as larger companies do, making them more sensitive to the economic cycle and to rising borrowing costs. The start of 2024 has also been challenging with the Russell 2000 index of small and mid-size companies lagging the S&P 500 with the widest gap since 1997. But a slow start is not a deal breaker: since 1979 (excluding the GFC in 2008), when the Russell 2000 has declined at the start of the year by at least 4%, median performance was a gain of 26.1% six times out of seven.

“You need to calm down”

As Howard Marks states in his classic book Mastering the Market Cycle: Getting the Odds on Your Side, investors need to understand where we are in the market cycle, in addition to investors’ psychological and emotional states and their concomitant behaviors. Small-cap stocks have endured a long winter of investors’ disinterest. This “doom loop” is evidenced by articles entitled “Death of Small Cap Equities”. Negative magazine cover stories can be viewed as contrarian signals. (The phenomenon even has a name “Magazine Cover Indicator”. The most famous example is the 1979 BusinessWeek cover story entitled, “The Death of Equities” which marked the start of a two-decade bull market.) The time when most investors are fearful or have already capitulated, often proves to be an excellent time to buy at bargain prices. Investors’ tendency to exaggerate both good and bad news can present attractive buying and selling opportunities.

“Shake it Off”

Investors have finally noticed that small-cap stocks are cheap on both a relative and absolute basis. They are cheap relative to both their 10-year average and to the large-cap index. The set-up for quality small caps has not been this attractive for a very long time. According to the latest Bank of America Global Fund Manager Survey, for the first time since June 2021, more managers expect that this year, large-caps will gain less than small-caps marking an inflection point.

As interest rates stability and potentially drift lower, smaller companies are likely to benefit the most and their wide valuation discounts will shrink. As there is a wide dispersion of quality in small-cap indices, bottom-up, prudent stock selection in the small-cap space is key to finding those beaten down gems with the potential to become multi-baggers.

“Ready For It”

What will drive small-cap outperformance in 2024? Earnings will be in the spotlight and are expected to rebound this year. An important trend to watch is some of the most promising young companies are choosing to stay private for longer, assuming they have the financial backing. One outcome of this is small cap indices, such as Russell 2000, now hold a higher number of unprofitable companies. Firms that generate free-cash-flow, have strong balance sheets, a large total addressable market, and capable management teams will become even more attractive within this universe and are (finally) poised for a re-rating.

– David Barr is chief executive of PenderFund Capital Management Ltd.


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