As published in Conseiller (in French) on 15 July, 2024.
The investing adage that returns are greatest where capital is most scarce applies well to small cap stocks. These firms, often founder-led or family-owned, tend to be less well capitalized than larger enterprises and they have suffered the most during the recent period of rising interest rates. But this is not the first time they have been disproportionally overlooked and unloved by investors, nor is it the first time that they are poised for outperformance. We have seen this love/hate story before.
Beginning in March 2009, at the trough of the Great Financial Crisis, through to September 2017, the S&P600 generated a 455% return compared to 346% for the S&P500. Investors who ventured into small caps at the start of the bull run enjoyed excellent returns. However, since 2021, larger cap stocks have outperformed smaller ones.
After Covid, as central banks began to raise interest rates to control rising inflation, smaller companies, including both the profitable and unprofitable ones, suffered the most from higher debt servicing costs and outflows of investor capital. In the Canadian small cap mutual fund categories assets decreased over 50% during the past decade.
This has created a negative feedback loop of fleeing capital and underperformance in this sector although we saw an inflection point during Q1 2024 with S&P TSX Small Cap Index outperforming the S&P TSX Composite Index.
Today, the Mag 7 represent over 30% of the S&P 500. As in every previous cycle, even the most popular companies, such as today’s darling Nvidia, a leader in AI technology, cannot sustain growth rates of 40% indefinitely. The wave of investor excitement around AI has driven up the prices of Microsoft, Alphabet, Meta and other mega caps and left smaller companies idling at the curb. This makes it an opportune time for investors to lean into quality small cap companies to add diversification to their portfolios and to potentially generate alpha over the long term. These are some of the catalysts that are likely to drive small cap performance in the next few years.
Catalysts for small cap outperformance
- Increase in IPOs and M&A activity
As market valuations rose in 2023 and in Q1 2024, some private companies will be tempted to go public within a year or two. This would be a positive tailwind for small caps drawing attention and capital to the sector.
- Better balance sheets
The potential for re-rating comes from improved balance sheets and increased cash flow metrics. Faced with dwindling access to capital, savvy small cap companies have over the past three years cleaned up their balance sheets and right sized their staffing levels. Some have become more receptive to overtures from potential acquirers who are attracted to their discounted valuations.
- Historical mean reversion
Quality small cap companies are undervalued on both an absolute and relative basis. The S&P600 trades at a discount of around 5.6% to large caps where historically it has traded at a premium. Given the current valuation multiples on small cap companies, a mean reversion alone would likely cause a multiple expansion. This is a favourable set up for smaller companies in the next market cycle.
- Private equity dry powder
During the past decade, investor flows have moved away from small caps into private equity. At the end of 2023, PE dry powder was $3.2 trillion. Higher interest rates led to a steep drop in exits and deals. The apparent break in the interest rate hiking cycle should restore animal spirits and spur M&As in the small cap sector.
To illustrate this positive trend, in June 2024, Copperleaf Technologies, a long-time holding in several of our funds, accepted a $1 billion offer from Industrial and Financial Systems (IFS), a Swedish provider of enterprise resource planning, asset, and service management software. The $12 offer price represents a 70% premium over Copperleaf’s share price on the last trading day before IFS submitted its proposal. We expect more such announcements in the coming years.The potential for small cap outperformance during the next economic cycle looks appealing as headwinds turn to tailwinds for astute investors.